student study guide · 2019. 6. 11. · student study guide macroeconomics in context third edition...

Student Study Guide

Macroeconomics in Context

Third Edition

Neva Goodwin, Jonathan M. Harris, Julie A. Nelson,

Pratistha Joshi Rajkarnikar, Brian Roach, Mariano Torras

Copyright © 2018 Global Development And Environment Institute, Tufts University.

Copyright release is hereby granted to instructors for educational purposes.

Students may download the Student Study Guide from http://www.gdae.org/micro.

Comments and feedback are welcomed:

Global Development And Environment Institute

Tufts University Medford, MA 02155

http://ase.tufts.edu/gdae

E-mail: [email protected]

http://www.gdae.org/micro

http://ase.tufts.edu/gdae

Chapter 1 – Economic Activity in Context 1

CHAPTER 1

ECONOMIC ACTIVITY IN CONTEXT Macroeconomics in Context (Goodwin, et al.)

Chapter Overview

This chapter introduces you to the basic topics of macroeconomics, and presents the main

macroeconomic goals: 1) living standards growth, 2) stability and security, and 3)

financial, social, and ecological sustainability. The chapter highlights that the goal of

living standards growth may or may not contribute to the general goal of human well-

being. The chapter also provides a brief overview of the major historical developments

in macroeconomics, from classical economics, to Keynesian and monetarist economics,

and finally to the challenges in the 21st

century.

Chapter Objectives

After reading and reviewing this chapter, you should be able to:

1. Distinguish the concerns of macroeconomics from microeconomics.

2. Define the difference between normative and positive questions.

3. Discuss the relationship between economics and well-being.

4. Identify and describe the three main macroeconomic goals.

5. Identify and distinguish the major historical traditions of economic thought.

Key Terms economics

microeconomics

macroeconomics

recession

unemployment

inflation

macroeconomy

global economy

economic actor (agent)

positive questions

normative questions

assets

well-being

living standards growth

economic growth

economic development

labor productivity

business (trade) cycle

technological progress

conscious consumption

restorative development

precautionary principle

contextual economics

classical economics

division of labor

specialization

capitalists

laissez-faire economy

Say’s Law

aggregate demand

Keynesian economics

monetarism


Active Review

Fill in the Blank

1. While the study of economic activities of individuals, households, and business at the

sub-national level is the concern of

the national and global level is the concern of

, the study of economic activities of

.

2. Questions about facts or “how things are” are

about values and “how things should be” are

questions, while questions

questions.

3. The three main macroeconomic goals identified in this chapter are ,

, and . 4. The process of moving from a situation of poverty and deprivation to a situation of

increased production and plenty is referred to as .

5. The increase in the level of production in a country or region is called

growth while improvements in diet, housing, medical

attention, education, working conditions, access to care, transportation,

communication, entertainment, etc. is called growth.

6. The fluctuations in the level of production, including recessions on the one hand

and booms on the other hand, is called .

7. The goal that recognizes a serious responsibility to future generations is the goal of

.

8. The school of economics that is associated with the idea that individual self-interest is

a positive force and that governments should let markets function without interference is

called .

9. The economist who argued that the market mechanism can fail by leaving insufficient

demand and that governments could intervene by increasing aggregate demand was

named .

10. The school of thought that argued that governments should aim for steadiness in the

money supply rather than play an active role is called .

True or False

11. Economic phenomena such as the rate of unemployment and inflation are studied in

microeconomics.


12. Living standards growth is defined as increases in the level of production in a

country or region.

13. During a recession, the economy often has higher rates of unemployment, whereas

during a boom, the economy often has higher rates of inflation.

14. Monetarists believe the government should change money supply to boost

aggregate demand during a recession.

15. According to the Keynesians, the government can reduce unemployment through

changes in its spending and taxation policies. Short Answer

16. What types of questions would concern microeconomics, versus macroeconomics?

17. How have economists traditionally defined “economic growth,” and how is that

different from “living standards growth”?

18. What are the “three basic economic questions” that economists often address when

examining how much economic output is produced?

19. Once countries already have a high level of production, how might they achieve

living standards growth?

20. Why is the goal of stability and security important to many people? What problems

typically emerge during periods of instability?

21. The goal of sustainability requires that we address what three questions?

22. Explain how the classical school views the role of markets and government

intervention in fighting business cycles.

23. Explain how Keynesian economics views the role of markets and government


24. Explain how Monetarist economics views the role of markets and government


25. Describe some of the key changes that the U.S. economy has undergone since

the 1980s.

26. What two developments are demanding new ways of looking at the economic world

in the 21st

century? What kinds of sustainability questions do they raise?


Self Test

1. With what kinds of topics does macroeconomics concern itself?

a. Economic activities of individual firms, households, and other organizations

b. Forces of supply and demand in a particular market

c. Consumer behavior and firms output decisions

d. The labor market, wages, and hiring decisions

e. Aggregate economic phenomena like the rate of unemployment and inflation

2. Which of the following is an example of a normative question?

a. What is the nation’s rate of economic growth?

b. What is the nation’s rate of inflation?

c. What is the nation’s rate of unemployment?

d. What is the nation’s level of GDP?

e. Is the goal of sustainability of greater importance than the goal of economic growth

as we move into the 21st

century?

3. Which of the following is one of the three macroeconomic goals discussed in the text?

a. Growth in the size of corporations

b. Living standards growth

c. Growth in trade and globalization

d. Technological innovation

e. None of the above

4. Which of the following is not an example of one of the three macroeconomic goals

discussed in the text?

a. Preventing the economy from experiencing too much unemployment.

b. Preventing the economy from experiencing too much inflation.

c. Keeping living standards high enough for people to live decent, meaningful lives.

d. Making sure the economy is sustainable into the future.

e. Providing the best environment for corporations.


5. What explains the fact that the value of global production grew by a factor of 6.7

between 1960 and 2015, while the value of global production per capita has grown by a

factor of 2.8?

a. Global population also grew, though not as fast as total production.

b. The increase in global production has occurred simultaneously with a decline in

global population.

c. The increase in global production has occurred simultaneously with growth in the

global workforce.

d. The increase in global production has occurred simultaneously with decline in

the global workforce.

e. The growth in the global population has been greater than the growth in global

production.

6. How is labor productivity defined?

a. The level of output produced per capita.

b. The level of output produced per worker (or worker-hour).

c. The level of output produced as a share of GDP.

d. The level of human capital in the workforce.

e. The level of output produced per capital input.

7. What problems are we most likely to see at which stage of the business cycle?

a. High inflation during recessions.

b. High unemployment during booms.

c. Low inflation during booms.

d. High unemployment during recessions.

e. Both high unemployment and high inflation during booms.

8. Why is the instability of the business cycle a problem?

a. During recessions there is high unemployment, and resources are underutilized.

b. High unemployment is associated with individual and social stress, such as

suicide, domestic violence, illness and crime.

c. During booms, high inflation can erode purchasing power, savings and pensions.

d. Unpredictable fluctuations in rates of inflation, interest rates, and foreign

exchange rates make it difficult for individuals and organizations to plan for the

future.

e. All of the above.


9. Which of the following does not describe the economic events of the Great Depression?

a. Stock markets plummeted in the 1929 stock market crash.

b. A lack of confidence in banks led to runs on the banks and bank failures.

c. Production dropped by about 30% between 1929 and 1933.

d. The unemployment rate peaked to 25% at the height of the depression.

e. The economic crises was short lived and markets quickly adjusted back to

equilibrium.

10. Which of the following are the three dimensions of sustainability as discussed in the text?

a. Ecological, financial, and social sustainability

b. Ecological, financial, and political sustainability

c. Ecological, financial, and cultural sustainability

d. Ecological, technological, and human sustainability

e. Ecological, technological, and social sustainability

11. Which of the following is not an issue concerning social sustainability?

a. The disparities between the “haves” and the “have-nots.”

b. The ability of the next generation to contribute to a healthy economy and society

c. The need for steady growth in production

d. The creation of social disruption and political strife e. The ability of the next generation to experience social and political participation and

inclusion.

12. Which of the following best describes the precautionary principle?

a. Clear cause and effect relationships must be established before taking action.

b. We should err on the side of caution when dealing with natural systems or

human health.

c. The benefits of economic production and growth outweigh the risks of damage

to natural systems or human health.

d. Business should not have to prove a product to be safe before being released on

the market; rather a product must be proven unsafe before it is banned and pulled

from the market.

e. We should take precautions before engaging in risky business investment.


13. Which of the following best describes the notion of conscious consumption?

a. making consumption choices based on advertisements

b. making consumption choices based on price of goods

c. making consumption choices considering the environmental and social

consequences of the choices made

d. making consumption choices based on cultural influences

e. making consumption choices based on income levels

14. Which of the following is not one of the ideas associated with the school of classical

economics?

a. Specialization and the division of labor

b. Laissez-faire and the functioning of markets free of government intervention

c. The pursuit of individual self-interest leads to positive economic outcomes.

d. Supply creates its own demand

e. Markets sometimes fail, necessitating government intervention.

15. Which of the following is not one of the ideas of Keynesian economics?

a. An economy can experience insufficient demand

b. Governments can step in to help boost aggregate demand

c. Changes in government spending and taxation can help keep employment rates up

d. Governments should focus on keeping the money supply steady

e. Lowering interest rates alone may be insufficient if investors lack the

confidence to engage in spending.

16. Which of the following was one of Keynes’s suggested solutions, and was not

generally adopted in the U.S. in the post-war era?

a. Changes in government spending to stabilize the business cycle.

b. The role of government in keeping interest rates low to stimulate investment.

c. The involvement of government in controlling of the level and direction of

national investment.

d. The role of government in purchasing goods and services to stimulate aggregate

demand.

e. The role of government in manipulating taxation to stimulate aggregate demand.


17. Which of the following contributed to rising unemployment and increased inflation in

the 1970s?

a. Declining profits of U.S. firms due to increased competition from other industrialized

nations

b. Decline in wages

c. High expenditures by the government

d. (a) and (c) only

e. (a) and (b) only

18. Which of the following is not one of the ideas associated with monetarist economics?

a. Free-market economy drives out inefficiencies in the economic system.

b. A smaller government is good for the economy as it encourages private

initiatives.

c. Efforts by the government to push unemployment too low could lead to inflation.

d. Governments should keep the money supply stable.

e. There are times when the government should take an active role by changing its

spending policies.

19. According to the text, which of the following issues, not previously a major concern

of macroeconomics, must macroeconomics confront in the 21st

century?

a. The ecological sustainability of our reliance on fossil-fuel based economic growth

b. The social sustainability of the traditional model of economic development with

the persistence of global poverty.

c. The problem of business cycle fluctuations in unemployment and inflation.

d. (a) and (b) only

e. None of the above.

20. Which of the following characterizes the environmental challenges of the 21st

century?

a. The impressive growth of global GDP in the 20th

century was accompanied

by a dramatic increase in CO2 emissions.

b. There are limits to the capacity of the environment to absorb the by-products of economic growth.

c. It is becoming more difficult for technological advancements to keep problems of

resource depletion and pollution at bay.

d. If continued at the current rate, the emissions of CO2 and other greenhouse gasses

may lead to dramatic disturbances to our environment and economy.



Answers to Active Review Questions

1. microeconomics, macroeconomics 2. positive, normative

3. living standards growth, stability and security, sustainability

4. economic development

5. economic, living standards

6. the business cycle

7. sustainability

8. classical economics

9. John Maynard Keynes

10. monetarist economics

11. False. They are studied in Macroeconomics.

12. False. Economic growth, not living standards growth, is defined as increases in the

level of production in a country or region.

13. True.

14. False. Monetarists argued that governments should focus on keeping the money

supply steady, even in a recession when unemployment was high.

15. True.

16. Microeconomics concerns itself with decision-making of individual consumers, firms

and other organizations, such as how much to consume or produce of a product,

while macroeconomics deals with aggregate production and expenditure, the level of

unemployment, inflation, and interactions with the global economy.

17. Economists have traditionally defined economic growth in terms of production of

goods and services, whereas the concept of “living standards growth” encompasses

the improvement in the quality of diet and housing, transportation and

communication, health care, education, working conditions, entertainment, and even

political freedom and social inclusion.

18. The three basic questions are: what is produced, how is it produced, and for whom is

it produced.

19. Once countries achieve a high level of production, they may achieve living standards

growth by improving cultural, educational and environmental conditions, raising the

quality of work-life, and promoting more equity.

20. The instability over the business cycle can be accompanied by high rates of

unemployment, which is associated with falling incomes and social stress, like

suicide, domestic violence, illness and crime. Alternatively the instability may result

in inflation, which can erode the purchasing power of income, or wipe out the value

of savings and pensions.

21. The goal of sustainability requires that we address whether economic activities are

financially sustainable, whether they are socially sustainable, and whether they are

ecologically sustainable.

22. The classical school believes in the smooth functioning of market mechanisms, and

that they work best when left alone. They generally do not think governments

should intervene, and think that often government intervention makes things worse.

23. Keynesian economics believes markets often fail and governments have a role to

intervene, especially in boosting aggregate demand during downturns.


24. Monetarist economics believes that the government should pursue a steady money

supply and not intervene in the market actively over the course of the business

cycle.

25. Since the 1980s, there have been periods of long economic expansions, through the

rate of growth during these expansions have been lower than that in previous decades.

Also, the occurrence of large asset bubbles, driven by speculation, has become more

common, real wages have remained stagnant, inequality has increased, and big

corporations have grown and more powerful.

26. Two developments that are demanding new ways of looking at the economic world in

the 21st

century are 1) the environmental impact of long-term fossil-fuel based

economic growth, particularly with the dramatic rise in CO2 emissions; and 2) the

persistence of substantial global poverty and its threat to social sustainability.

Answers to Self Test Questions

1. e

2. e

3. b

4. e

5. a

6. b

7. d

8. e

9. e

10. a

11. c

12. b

13. c

14. e

15. d

16. c

17. d

18. e

19. d

20. e

Chapter 2 – Useful Tools and Concepts 1

Chapter 2

USEFUL TOOLS AND CONCEPTS Macroeconomics in Context (Goodwin, et al.)

Chapter Overview

This chapter introduces standard concepts of economic modeling, efficiency, scarcity,

opportunity cost, the Production Possibilities Frontier, and includes a review of graphing

techniques. It describes two different macroeconomic models: the neoclassical model

and the contextual model. It also provides an overview of the three spheres of economic

activity: the core sphere, the public purpose sphere, and the business sphere. In this

chapter you will see these concepts set into a broader context of concern for well-being.

Chapter Objectives


1. Distinguish and differentiate among the different methods of investigation:

empirical investigation, theoretical investigation, and historical investigation.

2. Understand the concept of economic tradeoffs (or opportunity costs) in the face of

abundance or scarcity.

3. Interpret and apply the Production Possibilities Frontier.

4. Describe the basic neoclassical model and the contextual model and discuss the

applicability of the models in depicting the real-world economy.

5. Describe the three spheres of economy activity.

Key Terms empirical investigation

time-series data

cross-sectional data

negative (or inverse) relationship

positive (or direct) relationship

theoretical investigation

model

ceteris paribus

historical investigation

abundance

scarcity

production possibilities frontier

opportunity cost

efficiency

basic neoclassical model

utility

core sphere

business sphere

public-purpose sphere

public good

regulation

direct public provision

informal sphere


Active Review

Fill in the Blank

1. The observation and recording of specific phenomena of concern is called

investigation, whereas the analysis based in abstract thought is called

investigation.

2. When researchers study past events, they are conducting a(n)

investigation.

3. The Latin phrase that means “all else constant” or “other things equal” is __________.

4. A diagram that shows the tradeoffs between production of two goods is called a(n)

.

5. You’re deciding whether to take an Economics course, or to take an Anthropology

course. The cost of taking the Economics course is the course

you’re having to forego, the Anthropology course.

6. A process that achieves the maximum value of output from the given set of inputs can

be described as .

7. The contextual model places economic activities within the ____________ and

_______________ context.

8. Cooking family dinner at home is an activity of the _________________ sphere.

9. Retailers such as Walmart, Target and Amazon are categorized under the

________________ sphere.

10. The two main economic functions of the public-purpose sphere are _____________

and ________________.


Qu

anti

ty o

f G

uns

True or False

Questions 11 to 13 refer to the production possibilities frontier shown below.

120 B C

D

A

0 50 100

Quantity of Butter 11. In the graph shown above, at point B, society is producing the maximum possible

amount of butter.

12. To move from point A to point B, society would have to cut down on its gun

production and increase butter production.

13. Starting from point B, society would have to shift substantial resources to increase

gun production.

14. Business interests are aligned with maximizing both financial profits and social well-

being.

15. The neoclassical model assumes that households make consumption decisions with the

goal of maximizing utility and that businesses make production decisions with the goal of

maximizing profits.

Short Answer

16. Assume you see that two macroeconomic variables are correlated with each other.

But you want to know if there’s an underlying or causal relationship between the two

variables. Would you use an empirical or theoretical investigation? Explain why.


Qu

anti

ty o

f G

uns

17. Why does a production possibilities frontier with increasing opportunity costs have a

bowed-out shape?

18. Consider the following PPF:

120 B C

D

A

0 50 100

Quantity of Butter Identify points that are a) inefficient and b) unattainable. How might a country be able

to produce a combination of goods and services that was otherwise unattainable?

19. Consider the following Production/Maintenance frontier.


What would the future PPF look like if a high level of resource maintenance (e.g. point B)

were chosen now? If a high level of resource depleting production (e.g. point A) were

chosen now?

20. Name the two actors in the basic neoclassical (or traditional microeconomic) model

of economics, and identify the assumptions the model makes of these two actors.

21. What does the basic neoclassical, or traditional, model of economics assume about

markets?

22. Discuss the two key features of the contextual model.

23. What is the distinguishing characteristic of institutions in the public purpose sphere?

24. What are some of the strengths of the business sphere?

25. Describe some of the key activities conducted in the core sphere.


Problems

1. Given the following data:

Year Unemployment Rate

(percent)

Inflation Rate

(percent per year)

1984 7.5 3.8

1985 7.2 3.0

1986 7.0 2.2

1987 6.2 2.7 Source: Economic Report of the President

a. Plot the unemployment data on a time series graph:

b. Plot the inflation data on a time series graph:

c. Now plot the unemployment and inflation data using a scatter diagram. Over any

period of years is there a positive relationship between the two variables? Over any

period is there a negative relationship?


2. Suppose that a society could produce the following maximum combinations of schools

and airplanes in a given year:

Alternative Quantity of schools Quantity of airplanes

A 100 0

B 80 30

C 60 50

D 40 60

E 20 65

F 0 68

a. Draw a production possibilities frontier (PPF) with schools on the horizontal axis and airplanes

on the vertical axis. Assume that the dots define a complete curve.

b. Is it possible and/or efficient for this society to produce 50 airplanes and 80 schools?

c. If society is currently producing at alternative C, then the opportunity cost of increasing the

output of schools from 60 to 80 is airplanes.

d. If society is currently producing at alternative E, then the opportunity cost of increasing the

output of schools from 20 to 40 is airplanes.

e. Is the opportunity cost of producing schools higher or lower moving from alternative C to B,

than moving from E to D? Explain why.


Era

sers

Self Test

1. Suppose an investigator has 50 years of data on rates of industrial production and

annual accumulations of CO2, and discovers a positive relationship between the two

variables. This is an example of what type of investigation?

a. Theoretical investigation

b. Empirical investigation

c. Historical investigation

d. Both A and B.

e. A, B, and C.

2. What does the Production Possibilities Frontier represent?

a. A catalog of all possible production options, represented as percentages.

b. The tradeoffs between production and consumption options.

c. The tradeoffs between possible production levels for two goods.

d. The amount that a society could produce if it devoted all its resources to

producing one good.

e. The possible gains from international trade in two or more goods.

3. Which of the following factors could expand a society’s production possibilities

frontier?

a. Increased butter production.

b. Shifting from one product to another.

c. Producing air pollution.

d. Depleting resources now instead of later.

e. Technological innovations.

Questions 4 and 5 refer to the following scenario:

C D

A

B

Pencils


An economy produces two goods: pencils and erasers. Use the graph shown above

depicting two possible production possibilities frontiers (PPFs) for this economy to

answer questions 4 and 5.

4. Which of the following events could cause the PPF to shift out?

a. Workers become less productive due to poor working conditions.

b. A hurricane destroys vital resources for pencil production.

c. A new machine is invented that makes it easier to produce both pencils and

erasers.

d. All production costs rise proportionally.

e. The cost of eraser inputs goes up.

5. Which of the following statements is true?

a. Moving from point C to point B requires shifting resources away from eraser

production and into pencil production.

b. Point B represents a less efficient resource mix than point C.

c. Depletion of nonrenewable resources could lead the economy to shift from

point C to point D.

d. Utility is maximized at point A.

e. At point A, society is producing all the pencils it can.

6. The nation of Anyplace produces two goods, chairs and tables. Anyplace can produce

the chairs and tables using either sustainable methods or resource-depleting methods.

If Anyplace chooses resource-depleting methods, which of the following statements is

true?

a. Eventually the PPF of Anyplace will shift outward (away from the origin).

b. Eventually the PPF of Anyplace will shift inward (toward the origin).

c. Eventually the PPF of Anyplace will pivot, causing a change in the slope of the

curve.

d. Eventually Anyplace will have to choose between producing only chairs or

producing only tables.



Ora

ng

es

Question #7 refers to the graph shown below:

B C

A

Apples 7. Which of the following statements is true?

a. Point A is inefficient.

b. Point B is inefficient.

c. Point A is preferred to point B.

d. Point B is preferred to point A.

e. Point C cannot be attained with current technology.

8. Suppose there is a production possibilities frontier (PPF) for wine and cheese. Which

of the following situations would shift the PPF inward (toward the origin)?

a. A severe weather event that destroys much of the economy’s productive

capacity.

b. Discovery of a new, cheaper source of milk for making cheese.

c. Increased popularity of wine, as compared with cheese.

d. A technological breakthrough.

e. Improved education of the work force.

9. Which of the following is not an example of resource management activities that can

lead to the PPF shifting outward in the future?

a. Investment in plant, equipment, and physical infrastructure

b. Investment in education and knowledge

c. Investment in international diplomacy and conflict resolution

d. Conservation of non-renewable resources such as fossil fuels

e. Mandatory overtime and cutbacks in vacations that leave workers exhausted

and in bad mental or physical health


10. In general, as production of a good increases, the opportunity cost of production

increases. How is this notion reflected in the graph of production possibilities frontier

(PPF)?

a. The PPF bows inwards (that is, looks like a slide or a valley)

b. The PPF bows outwards (that is, looks like a hillside).

c. The PPF shifts in response to technological change.

d. The PPF shows production of one good at a time.

e. The PPF becomes flatter as resource availability increases.

11. Which one of the following is not an assumption of the basic neoclassical model?

a. The actors in the economy are assumed to be households and firms

b. Firms are assumed to maximize profits

c. Households are assumed to maximize utility

d. Markets are assumed to be perfectly competitive, with prices determined by

supply and demand

e. Communities are assumed to look after resource management and

environmental protection

12. Which of the following statements below best fits the basic neoclassical model’s

perspective?

a. Adam thinks that self-interested maximizing behavior and free markets lead to

the best of all possible worlds.

b. Karl thinks that workers are squeezed by greedy, profit-hungry bosses.

c. Joseph experiences the booms and busts of the economy as if it were a

rollercoaster ride.

d. John thinks the economy is like an elevator that can get stuck in the basement,

and can only be fixed by an elevator repairman.

e. Julie values the work of volunteers and non-profit organizations in their

communities that keeps the economy strong and vibrant.

13. Which of the following statements below best fits the contextual model’s perspective?

a. Markets are always perfectly competitive.

b. Non-market production such as cooking, cleaning and caring for children should

be included in our economic model

c. The government should focus on helping businesses maximize profits.

d. The core sphere is primarily responsible for all resource management activities.



14. Which of the following statements is FALSE?

a. The neoclassical model identifies firms and households as the two main economic

actors.

b. The neoclassical model assumes that firms always maximize profits.

c. The contextual model focuses only on market activity.

d. The contextual model considers the environmental costs of economic activity.

e. There is some overlap between the neoclassical and the contextual model.

15. Which of the following is an example of a core sphere activity?

a. James plays a game of catch with his nephew.

b. Martha works at a bank.

c. A local fire department responds to local emergencies.

d. A national government purchases weapons.

e. A publicly funded state college provides education.

16. The activities of the U.S. Environmental Protection Agency would be characterized

as part of

a. The core sphere

b. The free rider sphere

c. The public purpose sphere

d. The business sphere

e. The informal sphere

17. Which of the following is an activity in the business sphere?

a. The government increases funding for public schools.

b. Tina sells home-made jam at the local market.

c. John helps a neighbor with yard work.

d. Martha volunteers to organize a community clean up event.

e. The local police department leads a training session on ensuring public safety.

18. Regulating the activities of financial institutions occurs in the

a. public purpose sphere

b. the informal sphere

c. the banking sphere

d. the core sphere

e. the business sphere


19. In the United States, the monetary value of the annual production of goods and services

was largest in:

a. the core sphere

b. the informal sphere

c. the public purpose sphere

d. the business sphere

e. the free rider sphere

20. Which of the following is not a characteristic of the informal sphere?

a. It is often dependent on family and community connections

b. It operates under government regulation and oversight

c. It is comprised of small scale market enterprises

d. It may include illegal activities and services provided “off the books”

e. The relative size of informal sphere tends to be larger in less developed countries



1. empirical, theoretical

2. historical

3. ceteris paribus

4. production possibility frontier

5. opportunity (cost)

6. efficient

7. environmental, social

8. core

9. business

10. regulation and direct provision

11. False. Society could produce more butter by producing fewer guns.

12. False. To move from A to B, society would have to decrease butter production and

increase gun production.

13. True. At point B, society is already employing many of its resources to produce guns.

Increasing gun production further will present high opportunity costs.

14. False. Some of the decisions made by businesses with the goal of maximizing profits

may come at the cost of social well-being. For example, cost-cutting measures such

as reducing pay or benefits to workers by hiring temporary workers, or dodging

environmental regulations to reduce production costs could have adverse impacts on

social well-being.

15. True. These are the key assumptions of the neoclassical model.

16. You would use a theoretical investigation. Empirical investigation is useful in

describing macroeconomic phenomenon, but may be inadequate in explaining

them. It may be clear that two variables are correlated, but unclear if there’s a

causal relation between the two. Theoretical investigation can more closely

examine complex relationships between phenomena.

17. The curve is bowed-out because some resources are better suited for the production

of one good (e.g. butter) rather than the other (e.g. guns). And as we try to produce

more and more of the other good (e.g. guns), it takes increasing amounts of resources

to do so and thus we incur increasing opportunity costs.

18. Point D is inefficient and point C is unattainable. One could get to an unattainable

point such as point C through technological progress, or the acquisition of

additional resources.

19. If Point B were chosen, the PPF would shift outwards, leading to a larger set of

production possibilities in the future. If Point A were chosen, the PPF would

shift inwards, leading to a smaller set of production possibilities in the future.

20. Firms and households. Firms are assumed to maximize profits, and households are

assumed to maximize their utility (or satisfaction).

21. It assumes that markets are perfectly competitive and smoothly functioning, and that

prices are determined purely by forces of supply and demand.

22. The contextual model places economic activity in the environmental and social

contexts. This model specifies economic activity as occurring within three spheres:

core, public purpose, and business.

23. The distinguishing characteristic of institutions in the public purpose sphere is that

they exist to serve the common good for a group larger than an individual or family,

and do not have the goal of making a profit.


24. Because business sphere is focused on profit maximization, they are likely to

encourage innovation and have higher efficiency.

25. Some of the key activities in the core sphere include producing of goods and services

(such as cooking, lawn mowing, and providing care to dependent members),

organizing savings and investment, allocating consumption spending, making labor

supply decisions, and organizing of the use of leisure time.


Unem

plo

ym

ent

Rate

(perc

ent)

In

flation R

ate

(perc

ent per

year)

Answers to Problems

1.a.

8

7

6

5

4

3

2

1

0

1984 1985 19 86 1987

Year

b.

4

3

2

1

0

1984 1985 19 86 1987

Year


Inflation R

ate

(perc

ent per

year)

c.

6

5

4

3

1987

2

1984

1985

1986

1

0

0 1 2 3 4 5 6 7 8

Unemployment Rate (percent)

There appears to be a positive (direct) relationship between unemployment and inflation

from 1984 to 1986 (both are falling), but an negative (inverse) relationship between them

from 1986 to 1987 (unemployment falls while inflation rises).


2. a.

b. No, 50 airplanes and 80 schools is unattainable, because it’s beyond the PPF.

c. To go from 60 to 80 schools, 20 airplanes must be given up. Thus the opportunity cost

of 20 schools is 20 airplanes.

d. To go from 20 schools to 40 schools, 5 airplanes must be given up. Thus, the

opportunity cost of 20 schools is 5 airplanes, starting from alternative E.

e. The opportunity costs of moving from C to B is higher than it is moving from E to D .

As we try to get more and more schools, we’re using resources not as well suited into the

production of schools, incurring increasing costs.


1. B

2. C

3. E

4. C

5. A

6. B

7. E

8. A

9. E

10. B

11. E

12. A

13. B

14. C

15. A

16. C

17. B

18. A

19. D

20. B

Chapter 3 – What Economies Do 1

Chapter 3

WHAT ECONOMIES DO Macroeconomics In Context (Goodwin, et al.)

Chapter Overview

This chapter introduces the four essential economic activities: resource management, the

production of goods and services, the distribution of goods and services, and the

consumption of goods and services. The chapter highlights resource management, a crucial

component in ensuring the environmental sustainability of economic activities. The chapter

also examines the activity of distribution. In the chapter, you will learn about ways in

which economists and others measure the extent of income and wealth inequality in an

economy. The chapter concludes with a description of the market system, including a

discussion of the institutional requirements of markets. It also introduces the concepts of

externalities, public goods, market power, transaction costs, information and expectations,

and concern for human needs and equity in order to demonstrate why markets, while

useful, are not on their own sufficient for organizing economic life in the service of well-

being.

Chapter Objectives


1. Define the four essential economic activities.

2. Define the five types of capital.

3. Explain the difference between stocks and flows.

4. Discuss the limitations of substitutability with respect to natural capital.

5. Understand the importance of maintaining capital stocks.

6. Describe the difference between exchange and transfer.

7. Define the difference between wealth and income.

8. Describe the distribution of income and wealth in the United States.

9. Describe how inequality is measured.

10. Distinguish the different meanings of the term “market”.

11. Describe the institutional requirements of markets.

12. Identify the advantages and limitations of markets

Key Terms

resource management

capital stock

natural capital

manufactured capital

human capital

social capital

financial capital

stock

flow

stock-flow diagram

production

inputs

outputs

waste products


distribution

exchange

transfer

in-kind transfers

consumption

saving

investment

depreciation

gross investment

net investment

renewable resource

nonrenewable resource

substitutability

sustainable socioeconomic system

restorative socioeconomic system

labor income

capital income

rent

dependency needs

social insurance programs

means-tested programs

proportional income tax

regressive income tax

progressive income tax

Lorenz curve

Gini ratio

capital gain

market (three meanings)

institutions

private property

implicit contract

explicit contract

physical infrastructure

free riders

externalities

transaction costs

market power

static analysis

dynamic analysis

market failure

Active Review

Fill in the Blank

1. Protecting wildlife in a national park is an example of the economic activity of

.

2. Gary’s Gasoline Station is for sale. Gary hopes to get a good price for the station in

part because he has built up a good reputation with customers. The good will of

Gary's customers is a form of capital.

3. The activity that turns inputs into new goods and services, or outputs, is called .

4. Your grandmother sends you a check for $100. This form of resource distribution

is referred to as a .

5. A gardener hears that a pesticide he has been using may have toxic effects on birds.

Rather than wait to find out what further studies show about its effects, he finds another

way of controlling insects in his garden. By taking action to protect birds, despite

uncertainty about the dangers of the pesticide, the gardener is exercising the

principle.


6. An oil executive states he is not concerned about the eventual depletion of fossil fuel

resources. "When we run out of oil," he says, “we’ll just switch to nuclear." The oil

executive is basing his argument on the notion of .

7. The activity of consumption and the activity of investment are linked by the activity

of , which is the refraining from consumption today in order to gain benefits in the future.

8. In one year a country adds to the capital stock with new investments, but during that

year some of its capital stock is reduced through depreciation. The resulting amount

of investment is called investment.

9. The graph that is used to depict income inequality, showing the percent of households

along one axis and the percent of income along the other, is known as the

curve.

10. If income were perfectly equally distributed within a country, the value of the Gini

ratio for that country would be .

11. If someone enjoys the benefit of a well-paved highway but refuses to pay for it, they

would be considered a .

12. You decide to buy a used car. You discover that it is hard to get information on the

quality of the used cars that are available. You have trouble communicating with the car

dealer. It takes a considerable amount of time to get the information you need to

successfully get the car you had in mind. In other words, buying a used car turns out to be

an activity with high costs.

13. A new factory begins discharging pollutants into a previously pristine river. Fish in

the river begin to die, and people who make their living through fishing have trouble

maintaining their catch. This factory is generating negative .

14. A professional musician practices piano every afternoon. Her neighbor listens to the

music and enjoys it. Through her activity, the musician is creating a positive

.


True or False

15. In a sustainable socioeconomic system, flows of goods and services come largely

from judicious use of renewable capital stocks.

16. The number of fish sold per day at Big City Fish Shop is an example of a stock.

17. Planting new trees in a forest is an example of making an investment.

18. The distribution of wealth in the U.S. tends to be more equal than the distribution of

income.

19. A public good is a good that is consumed by the public.

Short Answer

20. Identify the four essential economic activities.

21. Name the five types of capital.

22. Explain the difference between a stock and a flow.

23. What are the two main forms of economic distribution? What is the difference

between them?

24. How does the approach of someone who has adopted the precautionary principle

differ from someone with a blind faith in substitutability, when it comes to a non-

renewable resource like fossil fuels? 25. What are the two types of government cash transfer programs in the U.S., used to

help households achieve income security? Provide examples of each. 26. What is the distinguishes a progressive income tax, from a proportional income tax,

or a regressive income tax?


27. What is a Lorenz curve? Explain how the Gini ratio uses the Lorenz curve to

measure the level of inequality in a nation’s income distribution.

28. The US Census Bureau has experimented with a variety of possible definitions of

personal income. The Gini ratio in the US varies somewhat, depending which definition

of personal income is used. If the Census Bureau starts with a measure of pre-tax money

income and then adds the value of health insurance fringe benefits paid by businesses for

their employees, as well as the value of net capital gains, how does the Gini ratio change? 29. Provide an example of a market that fits the first meaning of markets (as a physical

place), and an example of a market that fits the second definition (as an institution).

30. List two advantages of markets identified by the authors of the text. 31. Identify the four institutional requirements of markets.

32. Identify six disadvantages of markets (i.e. cases of market failures).

Problems

1. Match the following items from column 1 with the appropriate examples from

column 2: Column 1:

a) natural capital

b) human capital

c) social capital

d) equity finance

Column 2:

1) clean water

2) a company's good reputation

3) a company uses its own funds to

pay for new machinery

4) literate workers


2. Identify which of the following resources are renewable vs. non-renewable resources.

Explain how their stock/flow diagrams would be different, assuming that when the

renewable resources are being renewed at the same rate as they are used up.

a. A forest

b. Reserves of petroleum and natural gas

c. Reserves of uranium

d. Fish in the seas

e. Wind energy

Problem #3 refers to following graph.

The graph above shows a Lorenz curve for income distribution in the country of

Utopia.

a. Label the horizontal and vertical axes on this graph.

b. In words, explain what information is communicated by the numbers shown on

this graph.

c. Suppose that the pattern of employment and wages in Utopia changes, so that now the

distribution of income is less unequal. On the graph, draw an example of a Lorenz curve

that could illustrate this result.


Self Test

1. Enjoying art at a museum is an example of

a. production

b. consumption c. exchange

d. transfer

e. resource management

2. Which of the following is an example of the economic activity of resource

management?

a. Cooking dinner

b. Operating a factory

c. Providing worker education

d. Drilling for oil

e. Buying a bicycle

3. Which of the following is an example of the economic activity of distribution?

a. A baker makes 10 loaves of bread.

b. A plumber fixes a leak.

c. The legal speed limit is raised from 65 to 75 mph.

d. A couple enjoys a walk in the forest.

e. A retired worker receives Social Security benefits.

4. Which of the following is an example of the economic activity of consumption?

a. A baker makes 10 loaves of bread.

b. A plumber fixes a leak.

c. The legal speed limit is raised from 65 to 75 mph.

d. A couple enjoys a walk in the forest.

e. A retired worker receives Social Security benefits.

5. Which of the following is an example of a stock?

a. The number of haircuts you got last year

b. The amount of water that passes over a waterfall per second

c. The number of screwdrivers sold by a hardware store each week

d. The number of fish produced at a hatchery each day

e. The number of goldfish in the pet store's aquarium


6. Which of the following activities would be described as a resource management

effort?

a. Limiting the use of fossil fuels in an effort to limit global warming

b. Harvesting fish at a high rate

c. Extracting oil from known oil reserves

d. Using a well-designed machine to process leather for shoes

e. Selling seeds on the international market

7. Many public health and environmental policy experts believe that when an activity

poses a threat to human health or the environment, action should be taken to address

that threat even when there is some scientific uncertainty about the issue. This

approach is known as

a. substitutability

b. the renewable resource rule

c. the precautionary principle

d. the sustainability principle

e. the fixed capital principle

8. A city government builds a new road. After five years the road develops some

potholes, making it less useful. This decline in the value of the road over time is an

example of

a. fixed inventory

b. flows of capital services

c. depreciation

d. substitutability e. a renewable resource

9. Which of the following is an example of a stock of natural capital?

a. The number of trucks owned by a company.

b. The new growth in a forest over a year.

c. The knowledge you have gained from your past education.

d. The amount of oil in an underground reserve.

e. Efforts to remove the effects of pollution from a river.

10. A diagram that shows how flows change the level of a stock over time is known as

a(n)

a. flow chart

b. flow diagram

c. stock-flow diagram

d. input-output model

e. capital stock diagram


11. Which of the following is an example of a transfer?

a. You get a new job.

b. You trade violin lessons for foot massages.

c. You buy a bag of groceries.

d. You make a donation to a local soccer team.

e. You buy stock in a start-up firm.

12. Which of the following statements is false?

a. Rules about what can be owned vary across time and across cultures.

b. If you have a use right to a good, you cannot necessarily sell that good.

c. Transfers are distinguished by being one-way.

d. Transfers are distinguished by being voluntary.

e. Controversy exists over what sorts of things may be privately owned.

Question #13 refers to the following graph:

13. According to the Lorenz curve above, which of the following statements is true?

a. The bottom 40% of households earn less than 20% of all income

b. The bottom 20% of households earn 20% of all income

c. The society shown here has complete income equality

d. The more the curve sags downward, the greater income equality

e. Both a and d are true



14. Referring to the graph shown above, the Gini ratio is equal to:

a. A/(A+B)

b. (A+B)/A

c. B/(A+B)

d. A/B

e. B/A

15. In the year 2010, suppose the Gini ratio for Canada is 0.3 and the Gini ratio for the

US is 0.5. In the year 2015, the Gini ratio for Canada rises to 0.35. Which of the

following statements is true?

a. Canada has greater inequality than the US.

b. Canada has greater inequality in 2015 than it did in 2010.

c. The US has greater equality than Canada.

d. Between 2010 and 2015, Canada’s Lorenz curve has become straighter (closer to

the diagonal line).

e. All of the above are false.

16. Which of the following statements is true?

a. The US has the lowest Gini ratio of all major industrialized countries

b. The US has the highest Gini ratio of all major industrialized countries

c. The UK has a higher Gini ratio than the US.

d. Countries with high levels of equality have high Gini ratios.

e. The US has a straighter Lorenz curve than any other major industrialized

country.


17. Which of the following statements about income inequality in the US is true?

a. Income distribution was most equal in 1968.

b. Income distribution was most equal in 1947.

c. Income inequality has declined steadily from 1947 to the present.

d. Income inequality has risen steadily from 1947 to the present.

e. The US has greater income equality than most industrialized countries.

18. Which of the following would not be considered a market by any of the three

meanings of markets?

a. Seattle’s Pikes Place Market, a tourist attraction known for its fish and flower

stands.

b. The mall of America in Minnesota, the U.S.’s largest retail and entertainment

complex.

c. The capitalist free market

d. The stock market

e. Marketplace, the radio program on national public radio.

19. Which of the following is not an example of an institutional requirement of markets?

a. The deed of a house, identifying its owner.

b. A police force devoted to combating theft.

c. A firm’s reputation for making quality products.

d. Reliable roads and bridges that won’t fall apart

e. Central planners who are able to allocate and distribute resources

20. A city government maintains local roads. This service is an example of:

a. A free rider

b. A public good

c. A positive externality

d. An external cost

e. A core sphere activity

21. Why are public goods often provided through government agencies and supported by

taxes?

a. Because they are goods that the public generally believes are valuable and

important for the smooth functioning of the economy.

b. Because the goods would not be well-provided by the private sector, since they

are non-excludable.

c. Because consumers of the goods have little incentive to pay for them, since

they are non-excludable.

d. Because of the problem of free riders, who would otherwise benefit from the

public good without paying for it.



22. Which of the following is an example of a positive externality?

a. A musician performs in a concert. People pay to listen to the concert.

b. An architect designs a house for herself to live in. She enjoys spending

time in the house.

c. A student volunteers in a shelter for the homeless.

d. A homeowner plants a tree for shade around her house. The tree also

provides shade for her next-door neighbor.

e. A teacher drives his car to work and gets stuck in a traffic jam.

23. Which of the following is an example of a negative externality?

a. A student receives a failing grade on a French exam.

b. Your roommate throws a loud party that keeps you awake all night.

c. You decide to take public transportation to work every day.

d. A group of farmers pool their resources to purchase seeds for next year.

e. You receive a letter saying your bank account is overdrawn.

24. A firm has an experienced worker who it has spent considerable time training. The

economy goes into a recession, but the firm is reluctant to lay off the worker. Searching

for another worker who is trained and trustworthy when the economy picks up again

would entail which kind of costs?

a. Opportunity costs

b. Implicit costs

c. Explicit costs

d. Transactions costs

e. External costs

25. Which of the following entities does not have substantial market power?

a. An oil company like Exxon Mobil.

b. A multinational soft drink corporation like Coca Cola.

c. A government agency like the Department of Defense.

d. A computer software company like Microsoft.

e. A flower seller at a local farmers’ market, where there are many flower

sellers.


1. resource management 2. social (capital)

3. production

4. transfer

5. precautionary (principle)

6. substitutability

7. saving

8. net (investment)


9. Lorenz

10. zero

11. free rider

12. Transaction (cost)

13. externality

14. externality

15. True

16. False, it’s a flow.

17. True

18. False, wealth is more unequally distributed than income is in the U.S.

19. False

20. The four essential economic activities are: resource management, production,

distribution, and consumption.

21. The five types of capital are: natural capital, manufactured capital, human capital,

social capital, and financial capital.

22. A stock is something whose quantity is measured at a point in time, whereas a flow

measures the quantity of something over a period of time.

23. The two main forms of economic distribution are exchange and transfer. Exchange

involves a two-way distribution, trading one thing for another, whereas a transfer

involves a one-way distribution, giving something with nothing specific expected in

return.

24. Someone with a blind faith in substitutability will think that the depletion of a non-

renewable resource like fossil fuels is not such a serious problem, since they have

faith that in the future other resources can cheaply be substituted for it. While

someone who has adopted the precautionary principle will think that we should err

on the cautions side and not simply assume that other resources can be cheaply

substituted for the non- renewable resource.

25. The two types of government cash transfer programs in the U.S., used to help

households achieve income security are social insurance programs (like Social

Security and Medicare) and means-tested programs (like welfare, food stamps,

housing subsidies).

26. A proportional income tax takes the same percentage of a person’s income, whether

they are rich or poor. A progressive income tax takes a larger percentage of income

from the rich, while a regressive income tax takes a larger percentage from the poor.

27. A Lorenz curve is a line that portrays a nation’s income distribution, by dividing up

households by into quintiles from poor to rich, and then plotting the cumulative

percent of income flowing each quintile of households. The Gini ratio measures the

level of income inequality by taking the area between the Lorenz curve and line of

perfect equality (A), divided by the total area under the line of perfect equality

(A+B). The higher the Gini, the more inequality there is in the income distribution.

28. It rises, since these benefits are enjoyed primarily by the middle class and the

relatively wealthy.

29. A local farmer’s market would be an example of a market understood as a

physical place with both buyers and sellers of a good. The market for goods

sold on eBay, the stock market or the market for oil, are examples of markets

understood as institutions.


30. Markets can be an efficient way of allocating resources. Markets involve

voluntary exchanges. Another advantage identified in the text is that markets

encourage innovation and creativity.

31. The four institutional requirements of markets are: private property, social

institutions of trust, good physical infrastructure, and money.

32. Six disadvantages or cases of market failure are: public goods, externalities, market

power, inequality, transactions costs, and information/expectations problems.

Answers to Problems

1. a) 1; b) 4; c) 2; d) 3

2. a) renewable; b) non-renewable; c) non-renewable; d) renewable; e) renewable.

For the renewable resources, if the incoming flows equal the outgoing flows, the size of

the stock will remain the same. For the non-renewable flows, there is no incoming flow,

thus the size of the stock will continually diminish as it is used.

3.

a. The horizontal axis should be labeled as “Percent of Households,” and the vertical

axis should be labeled as “(Cumulative) Percent of Income.”

b. Based on this graph, we can see that the poorest 15% of households in Utopia

receive 5% of total household income.

c. The curve will shift upward, toward the diagonal:


1. B 2. C

3. E

4. D

5. E

6. A

7. C

8. C

9. D

10. C

11. D

12. D

13. A

14. A

15. B

16. B

17. A

18. E

19. E

20. B

21. E

22. D

23. B

24. D

25. E

Chapter 4 – Supply and Demand 1

Chapter 4

SUPPLY AND DEMAND Macroeconomics in Context (Goodwin, et al.)

Chapter Overview

In this chapter, you’ll find the basics of supply and demand analysis. As you work through

this chapter, you will start learning how to manipulate supply and demand curves as a way

to analyze the relationships among prices, volume of production, and other factors. You

will learn about the various factors that can shift a supply or demand curve up or down, the

concepts of equilibrium and market adjustment and the concept of elasticity. You will also

be asked to consider how supply and demand analysis may or may not be useful in

explaining macroeconomic phenomena.

Objectives


1. Understand the characteristics of the market theorized in the Classical model.

2. Interpret supply and demand curves.

3. Understand the difference between a change in supply (demand) and a change

in the quantity supplied (demanded).

4. Describe some changes that would cause a shift in a supply curve, or a

demand curve.

5. Explain how price adjusts due to changes in supply and demand.

6. Identify what is meant by the “price elasticity” of demand (supply).

7. Appreciate the usefulness and limitations of the theory of supply and demand

in the real world, and its relevance to macroeconomics. Key Terms

perfectly competitive markets

self-correcting market

supply curve

change in quantity supplied

change in supply

demand curve

change in quantity demanded

change in demand

substitute good

complementary good

surplus

shortage

market equilibrium

theory of market adjustment

market disequilibrium

price elasticity

price elasticity of demand

price elasticity of supply

quantity adjustments

menu costs

speculation

speculative bubble

subprime mortgage


Active Review

Fill in the Blank

1. Assume that in the market for tulips, there are hundreds of buyers and sellers of

tulips, all of the tulips are identical, and it is extremely easy for anyone to become a

tulip farmer and sell tulips. This market would most likely be characterized as a

market.

2. You decide to take a Uber ride when there is a heavy rain and most buses are

running late. Many other commuters are also using Uber services for the same

reason, which instantly increases the price of Uber rides. This market would be

characterized as a market.

3. A curve indicating the quantities that buyers are willing to purchase at various prices

is known as a(n) curve.

4. You notice that when the price of gasoline goes up in your town, people buy less

gasoline. Assuming that nothing else has changed, this would be described by

economists as a change in .

5. Tabitha needs furniture for her room. She is deciding between a medium-sized couch

and a large armchair. Either the couch or the armchair could fulfill her need for sitting

space in the room. The couch and the armchair can be referred to as

goods.

6. When people eat french fries, they like to put ketchup on them. Due to an increase in the

price of french fries, total sales of french fries decrease. At the same time, ketchup sales

also decrease. This phenomenon can be explained by noting that french fries and

ketchup are goods.

7. Surplus and shortage are both instances of .

8. A curve indicating the quantities that sellers are willing to offer at various prices is

known as a(n) curve.

9. In general, in a basic model showing supply and demand, if the supply curve shifts

to the right, equilibrium price will ____________ and equilibrium quantity will

___________.

10. Henry notices that when the price of bread goes up by 10%, the quantity demanded

falls only slightly. To measure by how much quantity demanded falls, Henry should

use the of demand.

11. When people rush to buy an asset because they expect the price to continue to rise

and thereby expect to profit from the asset’s appreciation in value, this can cause the

emergence of a .


True or False

12. The quantity of rainfall is a nonprice determinant of the supply of lemons.

13. The demand curve for a good shows the same information as the demand schedule.

14. The level of income (or ability to pay) enjoyed by potential buyers is one factor

determining the location of the demand curve.

15. In general, an increase in demand tends to increase equilibrium price and decrease

equilibrium quantity.

16. In a situation of shortage, the quantity supplied exceeds the quantity demanded.

Short Answer

17. Why do demand curves generally slope downward?

18. Explain the difference between a change in quantity demanded and a change in

demand.

19. A U.S. car manufacturer has produced a lot of SUVs, but now is having difficulty

selling them at the price it had intended to sell them for. The cars are sitting at the

warehouse unsold. Is this market in equilibrium? Explain.

20. A new movie is released after having been heavily promoted to teenagers. On the

first night, the tickets sell out and there are still teenagers waiting outside theaters,

desperate to see the movie and unable to get a ticket. Is this market in equilibrium?

Explain.

21. What is the mathematical definition of price elasticity of demand (supply)?

22. Provide an example of a market in which prices may adjust very slowly; and an

example of a market in which prices may adjust very quickly.


Price

of

Ca

rs

Problems

S

1

D1

Quantity of Cars

1. For the following questions, refer to the graph shown above.

a. Label the equilibrium point as E1, the equilibrium quantity as Q1, and the

equilibrium price as P1.

b. Show how the supply curve will change if car manufacturers achieve a

technological breakthrough that allows them to produce cars more cheaply.

c. If the price stayed at P1, would a surplus or a shortage result from the

technological breakthrough described in part (b)? Answer in words, and show on

the graph.

d. Assuming market forces work quickly, show the new equilibrium price to which

the market will adjust. Label this point as E2. Label the new equilibrium quantity

as Q2, and the new equilibrium price as P2.

e. In words, summarize the information that you have shown in your adjustments to

the graph in parts (a) through (d).


Price

of

Hard

cove

r D

ictionaries

2. The following graph shows supply and demand for hardcover unabridged English

dictionaries. Suppose that a new dictionary resource is created on the Internet, decreasing

people’s interest in buying large dictionaries in book form. For the questions below, state

the answer in words and, where relevant, diagram your answer.

S

D

Quantity of Hardcover Dictionaries

a. What happens to the demand curve for hardcover dictionaries, as a result of this

Internet innovation? (Answer in words and diagram.)

b. What happens to the supply curve as a result of the Internet innovation? (Answer

in words and diagram.)

c. What happens to the price of hardcover dictionaries as a result of the innovation?

Show the new price level on the graph you drew for part (b). 3. Refer again to the graph above, showing the market for hardcover dictionaries. What

are the two types of change in this market that would lead the equilibrium price to rise? 4. In a popular new movie, a central character spends much of his time sitting on a white

deck chair. Suddenly, white deck chairs come into fashion and everybody wants one.

The graph below shows the market for deck chairs before the movie came out.


Pri

ce

of d

eck c

hair

s

S

D

Quantity of deck chairs

a. On the diagram above, show what happens to the market for deck chairs as a

result of the movie.

b. Show the size of the shortage that exists in the short term, before the market

adjusts to equilibrium.

c. Label the new equilibrium point as E2.

5. Using the same example of the market in white deck chairs, describe and, on separate

graphs, show the changes in equilibrium price and quantity that would occur in response

to the following events.

a. A key input for making deck chairs becomes more expensive (ceteris paribus).

b. In a highly publicized event, someone falls off a poorly constructed deck chair

and sustains a serious head injury (ceteris paribus).


Pri

ce o

f A

par

tmen

ts (

in $

1000s)

Self Test

1. Which of the following is a characteristic of the sort of market imagined by classical

macroeconomists?

a. A market with speculation

b. A market with only one seller

c. A market with long-term contracts

d. A perfectly competitive market

e. A long supply-chain market

2. Which of the following is true for a “self-correcting” market?

a. The government sets the price and the market respects that decision.

b. Imbalances between buyers and sellers are automatically reduced through

changes in prices

c. Sellers use their market power to set prices high and persistent surpluses are the

result.

d. Buyers use their market power to set prices low and persistent shortages are the

result.

e. Sellers use their market power to set prices high and persistent shortages are the

result.

Questions 3 to 5 refer to the following graph:

The Supply Curve for Apartments

101

100

99

98

97

96

95

94

93

92

91

90

89

S

0 1 2 3 4 5 6 7 8 9 10 11

Quantity of Apartments


3. Based on the figure above, how many apartment owners would be willing to sell their

apartments for $91,000?

a. None

b. One

c. Two

d. Six

e. All ten apartment owners

4. In the scenario depicted in the figure above, up to ten apartments may be available for

sale. Suppose that ten more apartment owners enter the market, for a total of twenty

available apartments. These new entrants into the market would be all willing to sell their

apartments for any price above $90,000. Which of the following statements accurately

describes the resulting change in the supply curve?

a. The supply curve shifts upward.

b. The supply curve shifts to the right.

c. The supply curve shifts to the left.

d. The supply curve becomes longer.

e. The supply curve can no longer be represented by a straight line.

5. In the situation described in question #4, how many apartment owners would be

willing to sell their apartments for $91,000?

a. None

b. One

c. Two

d. Ten

e. Eleven

6. Which of the following statements is true, regarding the supply of a particular good,

and that good’s own price?

a. A price increase shifts the supply curve to the right.

b. A price decrease shifts the supply curve to the right.

c. A price increase shifts the supply curve downward.

d. A price change alone does not shift the supply curve.

e. A price change is the only way to shift the supply curve.


Pri

ce o

f R

ugs

($)

Question #7 refers to the following graph.

100 S2 S1

80

60

40

20

0

0 10 20 30 40 50

Quantity of Rugs

(Number per month)

7. The graph shown above depicts two possible supply curves for production of

handmade rugs. S1 is the initial supply curve, and S2 is the new supply curve after a

change has occurred in the market. Which of the following events could have caused this

shift?

a. Several rug makers have left the market, making handmade rugs more scarce.

b. Several new rug makers have entered the market, making handmade rugs more

plentiful.

c. The price of thread used in rugs has dropped, making it cheaper to produce rugs.

d. Rugs have come into fashion, so buyers want more of them.

e. Rugs have gone out of fashion, so buyers want fewer of them.

8. Which of the following is an example of movement along a supply curve?

a. The quantity of apples offered for sale increases as the price of apples rises.

b. An apple orchard burns down in an accidental fire, decreasing the number of

suppliers on the market.

c. Thanks to good weather conditions, apple growers enjoy a bumper crop this year.

d. The price of pears doubles, increasing demand for apples.

e. The price of fertilizer increases, making it more expensive to produce apples.


Pri

ce o

f S

ofa

s ($

)


50

45

40

35

30 D1

25 D2

20

0 5 10 15 20 25

Quantity of Sofas

9. Assume that sofas and arm chairs are substitute goods. The graph shown above

illustrates the demand curve for sofas. Which of the following events could have

triggered the shift in demand from D1 to D2, as shown above?

a. The price of sofas increased.

b. The price of armchairs increased.

c. The price of labor for making sofas increased.

d. The price of sofas decreased.

e. The price of armchairs decreased.

10. A bike shop in a small town has received a shipment of 10 new bicycles. The shop

offers the bikes for sale at a price of $300 each. At this price, however, there are only

two people in town who are willing to buy a bicycle. This situation can be described as

a. disequilibrium

b. shortage

c. surplus

d. equilibrium

e. both a and c are correct


Questions 11 to 13 refer to the following graph.

14 13

12 11 10

9 8 7 6 5 4 3 2 1 0

S

D 0 1 2 3 4 5 6 7 8 9 10

Quantity of Cars

11. When the price of cars is $5000, which of the following terms is not an accurate

description of the situation?

a. Quantity demanded exceeds quantity supplied.

b. A shortage exists.

c. The market is in disequilibrium.

d. Fewer than five cars are available for sale.

e. The market is in equilibrium.

12. Beginning from the price of $5000, which of the following events would be predicted

by the theory of market adjustment?

a. Some buyers who are willing to pay more will bid the price of cars up.

b. The market will remain in disequilibrium.

c. Prices will fall.

d. All buyers will remain in the market.

e. The supply and demand curves will shift to achieve equilibrium.

13. Now suppose that the local government invests in a new, very efficient fleet of buses.

Now, it is easy and affordable to get from one place to another without having your own

car. What change in the graph shown above is most likely to result from the new bus

service?

a. The supply curve shifts to the right.

b. The supply curve shifts to the left.

c. The demand curve shifts to the right.

d. The demand curve shifts to the left.



14. Suppose the demand curve for gasoline shifts to the right, as global demand from

India and China increases. Suppose also that new discoveries of oil enable an increase in

the supply of gasoline to be sold on the market. Assuming that nothing else changes,

what is the likely effect on the equilibrium price of gasoline?

a. The equilibrium price rises.

b. The equilibrium price falls.

c. The equilibrium price remains the same.

d. The effect on the equilibrium price is uncertain, as it depends of the extent of

the shifts in supply and demand.


15. Suppose we observe an increase in the world price of corn. Which of the following

could have caused the price increase?

a. An increase in the demand for corn by households in China and India.

b. An increase in the demand for corn for use in ethanol production in the U.S.

c. A fall in the supply of corn due to a drought in Australia.

d. A rise in the price of fertilizer, a key input in the production of corn.


16. Suppose the price elasticity of demand for oil is found to be very inelastic. Which of

the following factors could account for its inelasticity?

a. Oil is a greatly needed item, as it is a key ingredient for gasoline and many

other industrial products and processes.

b. There are few substitutes available for oil.

c. Oil accounts for a very small part of consumers’ budgets, so an increase in the

price of oil is barely noticed by consumers.

d. Oil accounts for a very large part of consumers’ budgets, so an increase in the

price of oil is quickly noticed and consumers greatly reduce the amount of oil

they purchase.

e. Both a and b.

17. Which of the following markets do not operate like the Classical’s perfectly

competitive and self-correcting mechanisms?

a. Markets with long-term contracts

b. Retail markets, such as for clothing, with prices posted on tags and long

supply chains

c. Restaurants with high menu costs

d. The market for computer operating systems

e. All of the above


18. Assume there’s been a fall in demand for automobiles in the U.S. Which of the

following best describes a “quantity adjustment” made by the U.S. automobile

producers?

a. Producers lower their price.

b. Although supply now is greater than demand at the initial equilibrium price,

producers continue to produce at the same rate, despite the resulting surplus of

automobiles on the market.

c. Producers primarily reduce their production levels, rather than lowering their

price.

d. Producers raise their price, hoping to maintain their profit margins.

e. Producers raise their production levels, to entice customers back with more

automobiles to choose from.

19. Which of the following markets have experienced speculative bubbles (somewhere,

at some point in history)?

a. The stock market

b. The real estate market

c. The market for mortgage-based securities

d. The market for foreign exchange

e. All of the above

20. Which of the following reflects a Keynesian view of how the market mechanism may

operate?

a. Sometimes price adjustments are very slow

b. Sometimes price adjustments are too fast

c. Sometimes the market can get stuck at an equilibrium that is undesirable.

d. The market mechanism often does not work smoothly, thus necessitating

some corrective measures by government.



1. perfectly competitive

2. self-correcting

3. demand

4. quantity demanded

5. substitute

6. complementary

7. disequilibrium

8. supply

9. decrease, increase

10. price elasticity

11. speculative bubble

12. True. For example, a drought would decrease the supply of lemons.


Price o

f C

ars

13. True.

14. True.

15. False. In general, an increase in demand tends to increase both equilibrium price and


16. False. In a shortage situation, the quantity demanded exceeds the quantity supplied.

17. The demand curve slopes downward because in general, the higher the price of the

good, the fewer people will want to buy it.

18. "Change in quantity demanded" refers to movement along the demand curve. For

example, if the price of apples rises, all other things being equal, people will buy

fewer apples; thus, the quantity demanded will decrease. A “change in demand”

refers to a situation in which the entire demand curve shifts. For example, if a large

number of new people move into your neighborhood, there will be a larger pool of

people interested in buying apples at the local grocery store.

19. No, this market is not in equilibrium; there is a surplus of SUVs.

20. No, this market is not in equilibrium; there is a shortage of movie tickets.

21. The price elasticity of demand is the percentage change in quantity demanded divided

by the percentage change in price. The price elasticity of supply is the percentage

change in quantity supplied divided by the percentage change in price.

22. In retail markets with long supply chains, prices may adjust very slowly. In stock

markets, prices may adjust very rapidly.

Answers to Problems

1.a.

S1

E1

P1

D1

Q1


Price o

f C

ars

P

rice o

f C

ars

P

rice

of

Ca

rs

1. b.

S1

S2

E1

D1

Quantity of Cars

1. c. The shift in the supply curve creates a temporary surplus.

S1

S2

E1

Surplus

D1

Quantity of Cars

1. d.

S1

S2

E1

P2

E2

D1

Q2

Quantity of Cars

1. e. The supply curve has shifted to the right. The equilibrium price has fallen, and

equilibrium quantity has risen.


Price

of de

ck c

ha

irs

Price

of

Hard

cover

Dic

tio

na

ries

Price

of

Hard

cover

Dic

tio

na

ries

P

P

2. a. The demand curve shifts to the left.

S

D2

D1


2. b. The supply curve does not shift.

2. c. The price of hardcover dictionaries at the new equilibrium, E2, is lower.

S

E1

1

E2

2

D2

D1


3. The equilibrium price could rise as a result of the supply curve shifting to the left (i.e. a

decrease in supply), or as a result of the demand curve shifting to the right (i.e. an increase

in demand).

4. a.. The demand curve shifts to the right, as shown below.

S

D2

D1



Price o

f deck c

hair

s

Price o

f deck c

ha

irs

Price o

f deck c

ha

irs

4. b.

S

shortage D2

D1


4. c.

S

E2

E1

shortage D2

D1


5. a. The supply curve shifts to the left, leading to a higher equilibrium price and lower


S2

S1

E2

E1

D1



Price

of

deck c

hair

s

5. b. The demand curve shifts to the left, leading to a lower equilibrium price and lower


S1

E1

E2

D2 D1



1. d 11. e

2. b 12. a

3. b 13. d

4. b 14. d

5. e 15. e

6. d 16. e

7. a 17. e

8. a 18. c

9. e (substitute

goods)

19. e

10. e 20. e

Chapter 5 – Macroeconomic Measurement: The Current Approach 1

Chapter 5

MACROECONOMIC MEASUREMENT: THE CURRENT APPROACH Macroeconomics in Context (Goodwin, et al.), 3rd edition

Chapter Overview

In this chapter, you will be introduced to a fairly standard examination of the National

Income and Product Accounts (the NIPA), but with a “contextual” flavor. You will learn

that the accounts have been created for specific purposes. The chapter explains what has

been included in the measurement of the GDP, and what has been excluded. The chapter

highlights how the production and investment undertaken in the “household and

institutions” and government sectors have historically been deemphasized in national

accounting, and how these have been completely ignored in common abstract

representations of the macroeconomy. You will learn how economic growth, nominal

GDP, real GDP, price indices, and national saving are commonly measured. You will

also be introduced to the simple representations of the components of GDP that are

deployed in the traditional macroeconomic model.

Chapter Objectives


1. Understand when the U.S. system of national accounts was developed, in the

context of the pressing problems of that time.

2. Identify the four sectoral classifications of the U.S. national accounts, and what is

included in each sector.

3. Identify what capital stocks are included in the U.S. national accounts.

4. Define the Gross Domestic Product, and identify what is included and excluded in

its measurement.

5. Understand and apply the three approaches to measuring GDP.

6. Calculate GDP growth rates, nominal GDP, and real GDP.

7. Identify commonly used price indices, and construct a constant-weight price

index.

8. Identify the saving identity in a closed economy, and in an open economy; define

the Net Domestic Product (NDP); and define Net Saving.

9. Understand the simplifying assumptions made by the traditional macroeconomic

model, and identify the model’s basic identity (taken from the spending

approach).

10. (Appendix) Understand the value and limitations of the chained dollar method in

measuring real GDP.


Key Terms

National Income and Product Accounts

(NIPA)

Bureau of Economic Analysis (BEA)

national accounting conventions

fixed assets

inventories

consumer durable goods

gross investment

net investment

depreciation

gross domestic product (GDP)

final good

intermediate good

value-added

imputation

closed economy

open economy

net exports

national income (NI)

nominal (current dollar) GDP

real GDP

base year

index number

GDP deflator

consumer price index (CPI)

rule of 72

net domestic product (NDP)

From Appendix:

quantity index

Fisher quantity index

chain-type quantity index

Active Review

Fill in the Blank

1. The U.S. government agency that publishes statistics on production, income,

spending, prices and employment is the .

2. The four sectors into which the U.S. national accounts are divided are the households

and institutions sector, the business sector, the government sector, and the

sector.

3. The BEA puts non-profit institutions serving households in the sector.

4. Equipment owned by businesses and governments, structures, residences, and

software are all forms of .

5. Cars, washing machines, refrigerators and other equipment that are purchased by

households and that typically lasts for longer than three years are called

.

6. A newly produced automobile that remains unsold at the end of the year is included as

in the manufactured capital stocks.

7. The GDP measures the total of goods and services

produced in a over a period of .


8. To estimate the value of services from owner-occupied houses, the BEA uses the

method of by taking data from the rental housing market.

9. The sum of all the production-related incomes (such as from wages, rents, and profits)

earned by all people and organizations located inside the United States is called

.

10. The measure of GDP that reflects the actual value of goods and service produced by

removing the effect of changes in prices is called GDP.

True or False

11. Often referred to as the “national accounts”, the National Income and Product

Accounts (NIPA) includes statistics on production, income, and spending.

12. Catholic Hospital, a non-profit hospital, would be included in the national accounts in

the households and institutions sector, whereas Hospital Corporation of America, a for-

profit hospital chain, would be included in the business sector.

13. A government agency, like the U.S Postal Service, which produces goods and

services for sale, would be included in the government sector.

14. In 2003, the BEA began including consumer durable goods in its measure of the U.S.

manufactured capital stock and in its measure of investment.

15. Net saving adjusts for what a country must put aside to replace capital goods that are

wearing out, by subtracting depreciation from gross saving.

Short Answer

16. When did the idea of creating a system of national accounts first take hold, and for

what purpose? What were the concerns of that time? And who created them?

17. How much of GDP (in terms of share of the total) was produced by the different

sectors (as defined by the BEA) in 2016? (That is, how much was produced by the

business sector, the household and institutions sector, and the government sector?)

18. Where are non-profit organizations put in the BEA’s 4-way classification?


19. What kinds of non-financial capital stocks are included in the accounting of national

non-financial assets? 20. What are the two components of manufactured capital stocks?

21. What are the three approaches to measuring GDP?

22. How does the government estimate the value of the services produced by

government and nonprofit institutions that are not sold on the market? And the value of

the services produced by households? 23. Why in 1996 did the BEA switch to calculate real GDP using the “chained-dollar

method” from the “constant-dollar method”? 24. When measuring price levels in the economy (such as when calculating the CPI

index), why is a weighted average used? 25. Why does a price index based on constant weights tend to overstate inflation in

periods after the base year when the price of one good is rising quickly compared to other

goods? 26. What is the saving identity in a closed economy? And in an open economy?


27. What simplifying assumptions does the traditional macroeconomic model make (in

addition to those made in the NIPA)?

Problems

1. Determine which of the following would be counted in the spending approach of GDP,

and which would not be counted. Identify the category under which it would fall (C, I,

G, NX, or not counted).

a. The housecleaning services of a stay-at-home mom.

b. The housecleaning services of the “Merry Maids” company.

c. The babysitting services of a babysitter whose earnings are kept “off the books” and

not reported to the tax authorities.

d. A brand new house built and sold this year.

e. A new car made by Ford in the U.S., and sold to a household in the U.S.

f. A new car made by Ford in the U.S, and sold in Mexico.

g. Sale of a 2012 used Ford car.

h. 3 shares of Ford Motor Company stock

i. A new car made by Ford in the U.S. but not sold by the end of the year.

j. A new car added to the fleet of taxis of Mr. Taxi Company.

k. A new bridge to accommodate all the new and used cars and taxis on the road.

2.

Use the following table to answer the next question:

Stage of Production Stage of production Sales value of material

Stage 1 Grapes produced in the vineyard

10

Stage 2 New wine produced at the winery, stored in oak barrels

15

Stage 3 Fermented wine stored in wine bottles

20

Stage 4 Wine bottles distributed by the wholesaler

25

Stage 5 Retail price of bottled wine sold to consumer

30


a. Assuming that no intermediate inputs are used other than the ones named, what is

the value added at each stage of production – Stage 1-5?

b. Using the value added approach, what is the total contribution to the GDP of this

chain of production?

c. Using the expenditure approach, what is total contribution to the GDP of this

good? Explain why the number you got in part c is (or is not) the same as that

from part b.

3. The small economy of the United States of Sustainability has only three companies: a

bicycle manufacturer, a wind energy producer, and an organic cheese company. The only

costs these companies have are the cost of their inputs and wages. Assume there are no

rents, no depreciation, and no net income payments from the foreign sector. Assume all

the output is sold to consumers as final goods. The companies’ profits = Value of output

(total revenues) – total costs.

Bicycle company Wind energy

company

Organic cheese

company

Cost of inputs $0 $0 $0

Wages $50 $75 $25

Value of output

(total revenues)

$100 $150 $50

a. Calculate the GDP of the United States of Sustainability using the income

approach.

b. Calculate the GDP of the United States of Sustainability using the spending

approach.

c. Calculate the GDP of the United States of Sustainability using the value-added

approach.

4. Assume a simple economy produces only two goods, corn and wheat. In the first year

100 bushels of corn are produced, and sold for $3 a bushel. Also in the first year, 50

bushels of wheat are produced, and sold for $5 a bushel. In the second year, 110 bushels of

corn are produced, and sold for $3.50, while 55 bushels of wheat are produced, and sold for

$5.50.


a. Calculate the nominal GDP in year 1 and 2.

b. Using the constant-dollar approach, calculate the real GDP in year 1 and 2. Take year

1 as the base year.

c. Calculate the growth in real GDP between years 1 and 2 (with year 1 as the base year).

d. Calculate a constant weight price index for the second year, using the first year as the

base.

e. What is the growth rate of prices (inflation rate) from the first to the second year? Self Test

1. A non-profit charity which provides support to low-income families is included by the

BEA in the

a. household and institutions sector

b. business sector

c. government sector

d. foreign sector

e. both a and c

2. Which of the following would not be included in the households and institutions

sector?

a. A non-profit hospital

b. The University of Michigan

c. The National Manufacturers Alliance, a non-profit institution serving for-profit

manufacturers.

d. The Museum of Fine Art

e. The United Autoworkers, a trade union for the employees of automobile

manufacturers.


3. Which of the following non-financial capital stocks are included in GDP?

a. Natural capital, manufactured capital, human capital, and social capital.

b. Natural capital, and manufactured capital.

c. Human capital, and social capital.

d. Manufactured capital only.


4. Which of the following is not included as a fixed asset in the national accounts?

a. Office equipment

b. Factories and office buildings

c. Houses and apartment buildings

d. Computer software

e. Inventories

5. Which of the following would not be included in the measure of U.S. GDP in the

current year?

a. A new machine, made in the U.S. and purchased that year for the Ford motor

company assembly line.

b. A Ford automobile newly produced that year in the U.S.

c. A Ford automobile, newly produced that year in the U.S. but unsold and

sitting in a warehouse.

d. Three shares of Ford motor company stock purchased that year in the U.S.

e. The steel produced and sold that year to make a new Ford automobile.

6. Which of the following would not be counted as an addition in the measure of the U.S.

GDP in the current year?

a. A car produced and sold in the U.S. by the Japanese-owned Toyota company.

b. A car produced in the U.S. by the U.S.-owned Ford motor company, and sold

in Japan.

c. Restaurant meals in the U.S. sold to Canadian tourists visiting the U.S.

d. Restaurant meals in Canada sold to U.S. tourists visiting Canada.

e. A car produced in the U.S. by the Japanese-owned Toyota company, and sold

in Canada.


Use the following table to answer the question #7, assuming that no intermediate inputs

are used other than the ones named:

Stage of production Sales value of material

Wheat grown by a farmer $0.50

Wheat milled by the miller $0.75

Bread made by the baker $1.00

Bread sold by a distributor $3.50

Retail price of bread to the consumer $4.00

7. What is the value added at all stages of the production process of the bread as

described in the accompanying table?

a. $0.50

b. $1.00

c. $4.00

d. $7.50

e. $9.75

8. Assume the government is trying to measure the value of production of a non-profit

institution providing non-market services in a community. The cost of office supplies

used per year is $5,000. The payroll expenses are $150,000 per year. The institution

owns its own building, which if it rented out would cost $12,000 per year. The value of

services production that would be imputed for this non-profit institution would be

a. $12,000

b. $150,000

c. $155,000

d. at least $167,000

e. It is impossible to calculate the value of services produced by this non-profit

institution if its services are not sold on the market.


9. Assume the following for a particular owner-occupied household: The value of the

services of the house, based on the imputed rental value, is estimated to be $1500 per

month. A gardener is hired for the upkeep of the grounds, and is paid $200 a month. The

cleaning, cooking, and childcare are all done by the mother, who also has a part-time paid

job outside the home. If she were to hire a cleaning service she estimates she would have

to pay $500 a month, and if she were to hire a nanny or babysitter she would have to pay

$800 a month. What would be the value of the services produced in this household as

currently measured by the BEA?

a. $200

b. $1,500

c. $1,700

d. $3,000

e. None of the value of services produced in this household would be included.

10. In 2016, how much of GDP was produced by the business sector, according to the

BEA?

a. 33%

b. 50%

c. 65%

d. 75%

e. 90%

11. In order to measure GDP by the spending approach, to highlight the portions that are

considered to be consumption vs. investment, which identity should be used?

a. GDP = Household and institution spending + Business spending + Net foreign

sector spending + Government spending

b. GDP = Personal consumption + Private investment + Net exports +

Government consumption

c. GDP = Personal consumption + Private investment + Net exports +

Government consumption + Government investment

d. a and c

e. none of the above.

12. Which of the following would be included in the income approach to measure GDP?

a. Wages and benefits, profits, rents

b. Wages and benefits, profits, investment spending

c. Wages and benefits, rents, investment spending, consumption spending

d. The value added in production



13. Which of the following would not be included in the U.S. GDP, as measured by the

income approach?

a. The wages earned by workers at a German company located in the U.S.

b. The profits earned by a German company from its plant located in the U.S.

c. The profits earned by a U.S. company from its plant located in China.

d. The rents earned by a U.S. landlord with rental properties.

e. The interest payments earned by a U.S. bank from its loans.

14. Which of the following is a price index?

a. GPI

b. HDI

c. PPI

d. REI


15. The price index that is most frequently reported in the news is the

a. Consumer price index (CPI)

b. Producer price index (PPI)

c. Earnings index

d. The GDP deflator

e. Export price index

16. The GDP deflator is measured as:

a. Nominal GDP divided by real GDP

b. Real GDP divided by nominal GDP

c. Real GDP multiplied by nominal GDP

d. The rate of change of nominal GDP

e. The rate of change of real GDP

17. The rule of 72 measures

a. A country’s annual growth rate of GDP.

b. A country’s growth rate over a short period of time.

c. The number of years it will take for a country’s GDP to grow by 72 percent.

d. The number of years it will take for a country’s GDP to double if it grows at a

constant rate.

e. How much a country’s GDP will grow over a 72 year period.


18. In recent years, which of the following characterizes the U.S.’s economic situation?

a. The U.S.’s net exports are positive.

b. The U.S. lends more to foreign countries than what it borrows from them.

c. The U.S. imports more than it exports, and finances this by borrowing more

from foreign countries than what it lends to them.

d. The U.S. imports more goods from foreign countries, but also provides more

lending to foreign countries than what it borrows from them.


19. (from Appendix) The chained dollar method in calculating the growth rate of real

GDP uses a

a. price index

b. Fisher price index

c. quality index

d. Fisher quantity index


20. (from Appendix) The Fisher quantity index and chain-type quantity index for

measuring real GDP growth rates

a. provide a unique average number for estimated growth

b. use a reference year equal to 100

c. involve complicated mathematical calculations

d. are not very accurate for years far away from the reference year

e. all of the above. Answers to Active Review Questions

1. The Bureau of Economic Analysis (BEA)

2. foreign

3. households and institutions

4. fixed assets (or fixed manufactured capital)

5. consumer durables

6. inventory

7. value, final, newly, country, time.

8. imputation

9. national income (NI)

10. real (GDP)

11. True.

12. True.

13. False, such an agency would be included in the business sector.

14. False, while the BEA did start including them in the measure of the manufactured

capital stock in 2003, consumer durables are still excluded in the measure of


investment.

15. True.

16. The idea for the national accounts came during the 1930s depression in the U.S., when

decision-makers wanted to get a better sense of by how much economic production

had fallen. Simon Kuznets was commissioned to produce the national accounts.

17. The business sector produced about 75.6% of GDP, whereas the household and

institutions sector produced about 12.6%, and the government sector produced about

11.8% of the total GDP.

18. It depends on who the non-profit organizations serve. The non-profit organizations

serving households are placed in the household and institutions sector. Those non-

profit organizations serving business are put in the business sector.

19. Only manufactured capital is included.

20. Fixed assets and inventories.

21. The three approaches are: the production approach, the spending approach, and the

income approach.

22. To measure the value of services produced by governments and non-profit

institutions, the government usually uses a method of imputation, by measuring the

value of inputs used (the cost of intermediate goods, payroll costs, etc.). It does not

measure the value of the services produced by households (aside from the services of

owner-occupied houses and any services that are paid).

23. The BEA made the switch from the constant-dollar method to the chained-dollar

method, because the latter has increased the accuracy of the GDP growth

calculations by yielding one unique estimated growth rate between any two years.

With the constant- dollar method, the growth estimate depends on which year is used

as the base year.

24. Because we want to give greater emphasis to prices at which many transactions are

made, and less emphasis to the prices of relatively minor goods and services.

25. Because people tend to buy cheaper substitutes instead of the good whose price is

quickly rising. But the constant-weight index includes the same quantities of the

expensive goods.

26. In a closed economy, Saving = Investment. In an open economy, Saving =

Investment + Net exports.

27. The simplifying assumptions are: 1) the household and institutions sector contains

only households. 2) only the business sector invests; the household and institutions

sector and the government sectors are assumed to only consume 3) only the business

sector produces


Answers to Problems 1.

a. Not counted

b. Consumption

c. Not counted

d. Investment

e. Consumption

f. Net Exports

g. Not counted

h. Not counted

i. Investment

j. Investment

k. Government investment

2.

a. Stage 1 = $10; stage 2 = $5; stage 3 = $5; stage 4 = $5; stage 5 = $5

b. $10 + 5 + 5 + 5 + 5 = $30

c. The expenditure approach also yields a value = $30 (the retail price of the bottled

wine sold to the consumer). In a simple economy, the value of GDP from the

value added approach = value from the expenditure approach = value from the

incomes approach. 3.

a. Using the income approach, where GDP = wages + profits. Calculating the

profits for each company: profits for the bicycle company = $100 -50 = $50

Profits for the wind energy company = $150 – 75 = $75

Profits for the organic cheese company = $50 – 25 = $25.

So GDP = ($50 + $75 + $25) + ($50 + $75 + $25) = $300.

b. Using the spending approach, GDP = $100 + $150 + $50 = $300.

c. Using the value-added approach: The value added of the bicycle company = $100

– 0 = $100; the value added of the wind company = $150 – 0 = $150; and the

value added of the cheese company = $50 – 0 = $50. So GDP = $100 + $150 +

$50 = $300. 4.

a. Nominal GDP in Year 1 = (100 × $3) + (50 × $5) = $550

Nominal GDP in Year 2 = (110 × $3.50) + (55 × $5.50) = $687.50

b. The real GDP in year 1 = nominal GDP in year 1 = $550

The real GDP in year 2 = (110 × $3) + (55 × $5) = $605

c. Growth in real GDP = 10%

d. The constant weight price index =

[(100 × $3.50) + (50 × $5.50)]/[(100 × $3) + (50 × $5)] ×100 =


113.636

e. The inflation rate = [(113.636 - 100)/100] × 100 =13.636%


1. A

2. C

3. D

4. E

5. D

6. D

7. C

8. D

9. C

10. D

11. C

12. A

13. C

14. C

15. A

16. A

17. D

18. C

19. D

20. E

Chapter 6 – Macroeconomic Measurement: Environmental and Social Dimension 1

Chapter 6

MACROECONOMIC MEASUREMENT: ENVIRONMENTAL AND SOCIAL DIMENSIONS Macroeconomics In Context (Goodwin, et al.)

Chapter Overview

This chapter provides an introduction to economic, social and environmental accounting. It also offers

a survey of several different measures of economic well-being and economic performance. You will

learn about the economic functions of the environment, and how a measure of and a value for these

environmental services could be incorporated into the national accounts. You will also learn about the

exclusion of household production in the national accounts, and how this exclusion can be remedied.

Objectives

After reading and reviewing this chapter, the student should be able to:

1. Explain why GDP should not be confused with national welfare.

2. Understand why GDP does not measure well-being.

3. Identify the dimensions of well-being as described by the Stiglitz-Sen-Fitoussi

Commission.

4. Explain trends in subjective well-being data across countries and across time.

5. Describe alternative measures of economic well-being including the Genuine

Progress Indicator, the Better Life Index and the Human Development Index.

6. Explain and Critique the historical exclusion of household production from the

national accounts.

7. Understand the methods used to measure household production and impute a

monetary value to it.

7. Identify and provide examples of the three economic functions of the

environment.

8. Identify how, conceptually, the depreciation of natural capital can be included in measures of

production and saving.

9. Understand the issues involved in assigning monetary values to environmental asset stocks,

depreciation, and service flows.

Key Terms

defensive expenditures

satellite accounts

subjective well-being

Better Life Index (BLI)

Human Development Index (HDI)

replacement-cost method

opportunity-cost method

green GDP

damage-cost approach

maintenance-cost approach


Active Review

Fill in the Blank

1. A measure of welfare based on survey questions asking people about their own degree of life

satisfaction is called _________________.

2. Additional or parallel accounting systems that provide measures of social and environmental

factors in physical terms, without necessarily including monetary valuation, are called

___________________.

3. A town is spending money to raise their dikes and strengthen their levees in order to prevent

the neighboring river from flooding the town. Such spending would be considered to be

.

4. A measure of well-being expressed in monetary terms that has been transformed from the Index

of Sustainable Economic Welfare (ISEW) is the .

5. The index of well-being developed by the UNDP in 1990 that combines measures of health,

education, and income is called the .

6. Suppose a policy-maker estimates the value of household production by the expenditure it

would take to pay someone else to do the same job. He or she would be using the

cost approach.

7. The three types of functions that the natural environment plays in economic life are

functions, functions, and functions.

8. The absorption and accumulation of mercury into the food chain would be an example of the

function of the environment.

9. The measure of national production that subtracts both the depreciation of

manufactured capital and the depreciation of natural capital is called

.

10. Suppose a policy-maker estimates the value of a forested hillside in preventing floods by the

expenditure that would be needed to repair flood damage in the neighboring town. He or she

would be using the cost approach.


True or False

11. Satellite accounts are a helpful way of measuring the monetary value of changes in a country’s

environmental resources.

12. Average subjective well-being grows as rapidly as GDP per capita.

13. The Genuine Progress Indicator and the Gross Domestic Product both exhibit strong upward

trends in the United States for the period 1950-2004.

14. The failure to subtract the lost household production as more women entered the paid labor

force over the last century means that the GDP growth over this period of time is overstated.

15. The first estimates of the value of household services in the U.S. were produced more

than 80 years ago.

16. Water filtration provided by wetlands is an example of a sink function of the

environment.

Short Answer

17. Identify and describe five critiques of GDP presented in the chapter.

18. How is the market-based welfare component of GPI estimated?

19. Identify the categories that are added in, and those that are subtracted for, when

calculating the GPI.

20. What might account for the deviations of the HDI rankings from the GDP? Why might a

country like Sri Lanka have a lower level of GDP per capita than Namibia, and yet have a

higher HDI ranking than Namibia?

21. What are the four variables that are used to construct the Happy Planet Index?


22. What have been some justifications given for the historical exclusion of household

production from the national accounts?

23. Is it easier or harder to incorporate household production into the national accounts, compared

to incorporating environmental assets and services? Explain.

24. What measure has been developed in recent years that subtract for the depreciation of

both manufactured capital and natural capital?

25. Why has it been difficult to produce a single estimate of an environmentally adjusted or

“greened” GDP? What are the two approaches that can be used to put a value on environmental

assets and services?

Problems

1. Suppose Country A (the Ukraine) built a nuclear power plant that had a large accident and led to

the release of radioactive iodine that damaged the population’s thyroids. It led to $1 million in health

costs. Country B (Poland) administered potassium iodide pills to the population, to protect the

population’s thyroids in the case of an accident. The protection pills cost the country $100,000.

Country C (Germany) decided to ban the building of nuclear power plants. What is the value of the

radioactivity-free air in Country C due to this ban of nuclear power plants:

a) measured in terms of the damage cost approach?

b) measured in terms of the maintenance cost approach?

2. According to the results of the 2005 U.S. time use survey, women spent an average of

2.3 hours per day on household activities such as housework, food preparation, yard work, or paying

bills, while men spent 1.4 hours per day (when averaged over all responses). Suppose these findings

reflect the hours spent in household production for a middle class professional couple, who can each

make $20 an hour in paid work. Suppose they can hire someone else to do these household activities

for them for $10 an hour. Estimate the daily value of these household production activities (assuming

no one else in the household is contributing to household production) using:

a) the opportunity cost method

b) the replacement cost method


3. Counting the GPI

Suppose the economists in the country Greenland have been counting the GPI and

currently have estimated Personal Consumption Expenditures to be $1,000. They still

need to account for the following entries. Finish the task for them, identifying whether

the entries would be added or subtracted (or simply excluded) when measuring the GPI.

Personal Consumption Expenditures = $1,000 Added (+) Subtracted (-)

National defense $100

Spending on new bridges $25

Net foreign borrowing $75

Damage from crime $50

Volunteer work in community

centers

$50

Oil tanker accident $30

Loss of wetlands $20

Helping kids with homework $40

Cooking of meals at home $30

Cost of commuting $15

Services of household washing

machines

$10

You clean your own house $50

Working overtime on Saturdays

(in your paid job)

$25

Value of higher education $40

Column Totals: Total GPI:


Self Test

1. According to the textbook, subjective well-being (SWB) tends to…

a. increase as GDP per capita decreases.

b. increases as GDP per capita increases, but at a diminishing rate.

c. does not show any relationship with regard to GDP per capita.

d. increase as GDP per capita increases, and does so at an accelerating rate.

e. is better understood when contrasted with GDP rather than with GDP per capita.

2. Jane buys a package of cigarettes. While her purchase would show up in the national accounts as

an increase in GDP, it is actually an example of

a. a purchase of a well-being reducing product

b. a defensive expenditure

c. loss of leisure

d. loss of human and social capital formation

e. unequal distribution

3. Nancy has cut back her paid work hours to part-time and spends some of her extra time

participating in her local community peace and justice group which engages in important

community-building activities. While her decision to reduce her paid labor activities would

show up as a decrease in GDP, it may actually increase well-being because it is an example of

a. a well-being reducing product

b. a defensive expenditure

c. loss of leisure

d. a gain in human and social capital formation

e. a well-being reducing production method

4. Which one of the following items is not subtracted when calculating the GPI?

a. cost of crime

b. lost leisure time

c. environmental costs

d. net foreign borrowing

e. government spending on highways and streets

5. Which one of the following items is added in when calculating the GPI?

a. net foreign borrowing

b. consumer durable assets

c. most government spending on goods and services

d. the services of consumer durables

e. paid domestic services


6. When tracking the trends in real GDP per capita and real GPI per capita from 1950 to 2004,

what are the findings?

a. Per capita GPI is lower than per capita GDP, and it has grown more slowly.

b. Per capita GPI is lower than per capita GDP, but it has grown more quickly.

c. Per capita GPI is higher than per capita GDP, and it has grown more quickly.

d. Per capita GPI is higher than per capita GDP, but it has grown more slowly.

e. Per capita GPI is about the same as per capita GDP, and they both have grown at

about the same rate.

7. Which of the following is not accurate?

a. The Better Life Index includes nearly a dozen dimensions of well-being.

b. The Better Life Index is more ambitious than the Genuine Progress Indicator.

c. The Better Life Index was launched by the Organization for Economic Cooperation and

Development.

d. The Better Life Index includes life expectancy at birth, years of formal education, and

real per-capita GDP.

e. All of these are accurate.

8. The HDI aggregates which three indicators in its index of well-being?

a. GDP, adult literacy and education, life expectancy.

b. GDP, income inequality, and access to medical care.

c. GDP per capita, adult literacy and education, income inequality.

d. GDP per capita, adult literacy and education, life expectancy.

e. GDP per capita, access to medical care, life expectancy.

9. Which of the following best reflects the trends found in the HDI rankings?

a. There is a strong correspondence between HDI and GDP per capita, as a high GDP per

capita is always associated with a high HDI ranking, and vice versa

b. Although there is a rough correspondence between HDI and GDP per capita, some

countries have low GDP per capita, yet high HDI rankings, and vice versa.

c. There is a weak correspondence between HDI and GDP per capita.

d. There is an inverse correspondence between HDI and GDP per capita, as

countries with high GDP per capita have low HDI rankings, and vice versa.

e. There is no correspondence between HDI and GDP per capita.

10. Comparisons between GDP and HDI reveal that

a. GDP is a good measure of well-being

b. GDP has significant shortfalls as a measure of well-being

c. The HDI has significant shortfalls as a measure of well-being

d. The GDP is a better measure of well-being than is the HDI

e. Neither the GDP nor the HDI can serve as measures of well-being


11. Which of the following would not be an example of household production that is currently

excluded from in GDP?

a. childcare

b. housecleaning

c. meal preparation

d. landscaping by a paid gardener

e. taking kids to afterschool activities

12. According to the most conservative estimates, what is the total value of household production in

the U.S.?

a. about 5 - 10% of GDP

b. about 15 - 20% of GDP

c. about 25 - 35% of GDP

d. about 40 – 50% of GDP

e. about 100% of GDP

13. Approximately what percent of all U.S. workers were full time homemakers in the U.S. in 2000?

a. about 5%

b. about 16%

c. about 35%

d. about 40%

e. about 56%

14. Which of the following is used to measure (or estimate) the quantity of unpaid, non- market core

sector production?

a. Satellite accounts

b. Time use surveys

c. Value added

d. The precautionary principle

e. The maintenance cost method

15. Which of the following best characterizes the shares of time women vs. men spent on the

household production activities of housework, food preparation, yard work, or paying bills,

when averaged over all responses, according to 2016 BLS survey?

a. Women and men spent an equal amount of time per day on household activities.

b. Women spent on average 2.2 hours per day, while men spent 1.4 hours per day.

c. Women spent on average 4.2 hours per day, while men spent 3.3 hours per day.

d. Women spent on average 1.5 hours per day, while men spent 0.5 hours per day.

e. Women did all the household activities, while men did none.


16. A lawyer decides to scale back her hours to part-time, in order to raise her small children and

care for her elderly parents. She takes a cut in her annual salary of $40,000, and lays off her

nanny who she was paying $25,000 per year. Her unpaid caring labor would be valued at

, according to the ___ approach.

a. $25,000, opportunity cost

b. $40,000, replacement

c. $40,000, damage cost

d. $25,000, maintenance cost

e. $25,000, replacement cost

17. Hiking on a beautiful mountain to enjoy nature is an example of what kind of function provided

by the environment?

a. resource function

b. environmental service function

c. sink function

d. all of the above

e. none of the above

18. Which of the following is not an economic function of the natural world?

a. Environmental service functions

b. Capital functions

c. Sink functions

d. Resource functions

e. All of these are economic functions of the natural world.

19. Suppose Town A has a factory that spews out heavy pollution and causes $2 million in health

costs to the population. Town B also has such a factory, but requires it to invest $50,000 in a

new scrubber on its smokestack that cleans up most of its pollution. The value of the unpolluted

air would be $2 million according to the …

a. maintenance cost approach.

b. damage cost approach.

c. replacement cost approach.

d. opportunity cost approach.

e. spending approach.

20. Suppose Town A does not chop down the forest on the hillside above it. Town B does chop down

its forested hillside, and a flood results in $1 million worth of damage to the town. Town C also

chops down its forested hillside, but spends $500,000 in raising and strengthening its dikes and

levees to guard itself from flood-damage. The value of the forest’s services to Town A would be

approach according to the approach.

a. $500,000, maintenance cost

b. $500,000, damage cost

c. $1 million, maintenance cost

d. $1 million, replacement cost

e. $1 million, opportunity cost



1. Subjective well-being

2. Satellite accounts

3. defensive expenditures

4. Genuine Progress Indicator (GPI)

5. Human Development Index (HDI)

6. Replacement

7. resource, environmental service, sink

8. sink

9. Green GDP

10. damage

11. False. Satellite accounts only measure changes in the quantities of environmental resources, not

changes in their monetary values.

12. False

13. False

14. True

15. True

16. False. It is an environmental service function.

17. The text identifies: household production, volunteer work, leisure, human & social capital

formation, interactions with the natural world, defensive expenditures, products that reduce well-

being, financial debt, and increases in inequality.

18. Starting with the category of Personal Consumption Expenditures (or Household Budget

Expenditures), defensive and regrettable expenditures and long-term household investments are

subtracted from HBE. Then, an adjustment is made for income inequality by subtracting the cost

of inequality. Finally, the value of provision of public goods and services that households

benefit from is added to estimate the total market-based welfare.

19. The GPI adds in services from human, social, manufactured, and natural capital such as unpaid

housework and parenting, higher education, volunteer work, the services of consumer durables,

and net capital investment. It also adds the value of public goods and services such as the

services of highways and streets. It subtracts defensive and regrettable expenditures and the

social and environmental costs of economic activities including the cost of crime, lost leisure

time, underemployment, commuting, automobile accidents, household pollution abatement,

water pollution, air pollution, noise pollution, loss of wetlands, loss of farmland, loss of primary

forests, resource depletion, carbon dioxide emissions damage, cost of ozone depletion, net

foreign borrowing, and the cost of consumer durables.

20. The deviations between the HDI and GDP rankings might be due to what is being produced in

the country (e.g. spending on weapons that are used in wars rather than spending on health and

education), and the unequal distribution of goods and services within a country. A country like

Sri Lanka might have better social infrastructure and less of a gap between rich and poor than

does Namibia.

21. Average life expectancy, average subjective well-being, inequality of outcomes, and ecological

footprint.

22. Some reasons have included: a. households are not producing economic goods; b. it’s too difficult

to distinguish household production from consumption; c. GDP measures just market production; d;

including household production would make too big of a change in the accounts.

23. It is easier, as one can follow the existing procedures already used to impute a value for


government production. It does not require the development of new techniques.

24. The Green GDP.

25. Because there is more than one way to put a measure on the value of environmental services. The

two approaches to measure environmental services are the damage cost approach and the

maintenance cost approach.

Answers to Problems

1. The value of the unpolluted air would be

a) $1 million in terms of the damage cost approach

b) $100,000 in terms of the maintenance cost approach

2. The couple spends a total of 3.7 hours per day on household activities. The value of these

household activities using

a) the opportunity cost method would be $74 per day

b) the replacement cost method would be $37 per day

3. Counting the GPI

Personal Consumption Expenditures = $1,000

Added (+) Subtracted (-)

National defense $100 Neither added nor subtracted. Excluded.

Spending on new bridges $25 +25

Net foreign borrowing $75 -75

Damage from crime $50 -50

Volunteer work in community

centers

$50 +50

Oil tanker accident $30 -30

Loss of wetlands $20 -20

Helping kids with homework $40 +40

Cooking of meals at home $30 +30

Cost of commuting $15 -15

Services of household washing

machines

$10 +10

You clean your own house $50 +50

Working overtime on Saturdays

(in your paid job)

$25 -25 (loss of leisure)


Value of higher education $40 +40

Column Totals: _+245_ _-215_

Total GPI: $1,030_ ($1,000 + 245 – 215 = $1,030)


Answers to Self-Test Questions

1. B

2. A

3. D

4. E

5. D

6. A

7. E

8. D

9. B

10. B

11. D

12. C

13. B

14. B

15. B

16. E

17. B

18. B

19. B

20. A

Chapter 7 – The Structure of the United States Economy 1

Chapter 7

THE STRUCTURE OF THE U.S. ECONOMY Macroeconomics in Context (Goodwin, et al.)

Chapter Overview This chapter will help you put macroeconomics in its “real world” context. The chapter

will provide you with some basic economic literacy, such as understanding the different

sectors in the U.S. economy, and the major industries within those sectors. It examines

the historical trends within these sectors, providing an overview of the changing

economic landscape of the U.S. economy. It also investigates several economic debates,

such as the loss of manufacturing jobs, the role of financialization in our economy and

the rising costs of health care.

Objectives After reading and reviewing this chapter, the student should be able to:

1. Explain what is meant by the primary, secondary, and tertiary sectors of an economy.

2. Describe the relative magnitude of these sectors in the United States, and how this has

changed over time.

3. Describe some major characteristics of agriculture, energy, and other primary sector

industries in the United States.

4. Describe some major characteristics of construction, textile manufacturing, and

automobile manufacturing industries in the United States.

5. Discuss various explanations given for the decline in manufacturing employment in the

United States.

6. Describe some major characteristics of service industries in the United States,

especially health care, education, finance, and retail services.

Key Terms

output sectors manufacturing productivity

primary sector financial assets

secondary sector financial institution

tertiary sector financialization

labor productivity


Active Review

Fill in the Blank

1. The harvesting of forest products would be a component of the __________ sector.

2. Whereas the extraction of oil would fall under the ________ sector, the refining of

petroleum would fall under the __________ sector.

3. Utilities, such as electricity production, are a component of the __________ sector.

4. Marketing and retailing are a component of the ______ sector.

5. The tertiary sector is also called the ____ sector.

6. The sector that dominates the U.S. economy, comprising about 68% of all output, is

the _____________ sector.

7. While the U.S. has less than ______ percent of the world’s population, it uses about

________ percent of the world’s energy.

8. ________ energy is the fastest-growing source of renewable energy in the United

States, followed by ________ energy.

9. Stocks, bonds, and money mutual funds are examples of _____________ assets.

10. Much of the non-monetized economic activity in the core sphere, if counted, would be

part of the __ sector.

True or False

11. The rudimentary processing of raw materials would fall under manufacturing in the

secondary sector.

12. The products produced in the primary sector are generally sold to consumers in

households.

13. The primary sector is no longer of great importance to the U.S. economy, given that

it represents less than 3% of the U.S. private economy and employs only 1% of U.S.

workers.

14. There has been evidence of adverse impacts of hydraulic fracturing on human

health and the natural environment.


15. The absolute number of manufacturing jobs peaked years ago in virtually all

industrial countries.

Short Answer

16. Briefly define the primary, secondary, and tertiary sectors.

17. How have the shares of the U.S. private economy attributed to each of the three

sectors in the U.S. changed over the last few decades of the 20th

century?

18. How have employment patterns in these three sectors changed since the 1960s?

19. What factor(s) explains the relative decline of the primary sector in the U.S.?

20. What are the current threats to agricultural productivity in the U.S.?

21. How does agriculture, an activity primarily in the primary sector, spill over into the

secondary and tertiary sectors?

22. The US energy output has increased significantly since 2012. What is one of the key

factors contributing to this increase?

23. Why is the manufacturing sector in the U.S. losing jobs?


24. Critics of the service sector complain that service jobs pay poorly. Is this true?

25. What are the four categories of the tertiary sector in the alternative categorization

developed by the authors of the textbook? What kinds of activities are included in each?

26. Why have services become such a significant part of the U.S. economy?


Problems

1. Suppose the table below represents the simple economy of Peaceland.

Industry Value Added (in millions of

dollars)

Percent of GDP

Agriculture 21 5.3

Transportation 34 8.5

Trade 50 12.5

Health care and social

assistance

21 5.3

Education 20 5

Construction 44 11.0

Arts and Recreation 11 2.8

Diplomacy & peacekeeping 80 20

Textile manufacturing 65 16.3

Waste management and

environmental stewardship

54 13.5

Economy Total 400 100%

a. Determine the size of the primary sector (in terms of value added and percent of

GDP).

b. Determine the size of the secondary (in terms of value added and percent of

GDP).

c. Determine the size of the tertiary sector (in terms of value added and percent of

GDP).

2. Suppose the simple economy of Peaceland, above, has decided to cut out some of

the activities of the “middlemen” – the people and organizations that are involved

in moving products from the producer to the final consumer. They have set up Fair

Trade initiatives and have established local farmers’ markets, in order to encourage

more of the value of the product to flow directly to the producer, rather than


flowing into the pockets of the middlemen. Suppose the table below represents the

simple economy of Peaceland after these changes.


dollars)

Percent of GDP

Agriculture 21 5.6


Trade 30 8


assistance

21 5.6

Education 24 6.4



Diplomacy & peacekeeping 80 21.3




54 14.4

Economy Total 375 100%

Determine the size of the primary, secondary, and tertiary sectors, in terms of percent of

GDP. How have the respective sizes changed compared to your answer in problem 1?

3. The oil (petroleum) industry plays an important role in our economy. Using the

supply and demand model from Chapter 4, determine how each of the following

events would affect the price of oil on the world market. Identify if the event would

cause a shift in supply or a shift in demand (ceteris paribus), in which direction, and

whether the equilibrium price of oil would increase or decrease.

a. OPEC engages in an oil embargo in 1973

b. Consumers in the U.S. and Europe start driving more fuel efficient cars in the late

1970s and early 1980s

c. Saudi Arabia departs from the OPEC agreement and increases its supply of oil in

the early 1980s

d. Consumers in the U.S. start driving more fuel inefficient SUVs and light trucks

with low gas mileage in the 1990s

e. The economies of China and India grow more rapidly in the early 2000s and

consumers buy and drive more cars

f. Oil production in Iraq, one of the three countries with the largest reserves of oil, is

disrupted after the U.S.-led war, invasion and occupation


Self Test

1. How large is the U.S. economy?

a. The largest in the world.

b. The second largest in the world, after China.

c. The third largest in the world, after China and India.

d. The fourth largest in the world, after China, India and Japan.

e. The fifth largest in the world, after China, India, Japan, and Germany.

2. Which of the following would be a primary sector activity?

a. Utilities

b. Construction

c. The selling of houses

d. A household growing food in their garden

e. A household whose members clean their house

3. Which of the following would not be an activity in the primary sector?

a. Agriculture

b. Commercial fishing

c. Mining

d. The timber industry

e. The food processing industry

4. Maria is a farmworker. Jose is a medical doctor. Robin is a construction worker.

Which of them works in the secondary sector?

a. Maria

b. Jose

c. Robin

d. All of them do.

e. None of them do.

5. Which of the following would not be an activity of the secondary sector?

a. Automobile manufacturing

b. Utilities

c. Construction

d. Food processing

e. Transportation of goods to market


6. Sami works on an oil rig. Luis works at an oil refinery. Indira works as a gas station

attendant. Which of them works in the tertiary sector?

a. Sami

b. Luis

c. Indira

d. All of them do

e. None of them do

7. Which of the following would not be an activity of the tertiary sector?

a. Cooking home-cooked meals

b. Home construction and renovation

c. Education

d. Services provided by the Red Cross

e. Firefighting services

8. Which of the following best characterizes the historical trends of the secondary sector

and its share of the U.S. private economy?

a. The share of the secondary sector continued to grow steadily throughout the 20th

century.

b. The share of the secondary sector started to decline in the early 1980s with the

growth of globalization.

c. The share of the secondary sector started to decline in the late 1960s.

d. The share of the secondary sector started to decline in the Great Depression of the

1930s.


9. Which of the following best captures how “value added” is distributed among

the sectors?

a. 3% in the primary sector, 68% in the secondary sector.

b. 68% in the secondary sector, 17% in the tertiary sector.

c. 68% in the primary sector, 17% in the tertiary sector.

d. 3% in the primary sector, 68% in the tertiary sector.

e. 68% in the primary sector, 17% in the secondary sector.


10. Which of the following is not one of the trends in agriculture in the U.S.?

a. The total farm population has declined.

b. The total number of farms has decreased.

c. The average farm size has decreased.

d. Output per acre has increased.

e. Output per worker has increased.

11. Which of the following is not one of the characteristics of agriculture in the U.S.?

a. Farms occupy about 42% of the land area in the U.S.

b. There are about 2 million farms in the U.S.

c. Over 90% of the farms are small family farms.

d. Large corporate farms account for about 66% of the value of agricultural output.

e. Almost all farm receipts come from selling crops.

12. Which of the following about energy in the U.S. is false?

a. As of 2017, the U.S. is the world’s second largest consumer of energy.

b. As of 2017, the U.S. is the world’s second largest producer of energy.

c. The U.S. has one of the highest per capita energy usage rates in the world.

d. The U.S. has one of the highest energy efficiency rates (energy used per dollar of

GDP) in the world.

e. The U.S. is heavily dependent on carbon-based fossil fuels for its energy use.

13. Which of the following accurately describes energy consumption in the

United States?

a. In percentage terms, natural gas is the biggest category of consumption.

b. In percentage terms, coal is the biggest category of consumption.

c. In percentage terms, nuclear power is the biggest category of consumption.

d. Over 80% of energy consumed in the U.S. comes from fossil fuels.

e. None of these are accurate.

14. “Fracking” is …

a. a non-toxic technique used to boost oil and gas production using water.

b. a relatively new technology that has the potential to dramatically boost biomass

production.

c. a cutting-edge technology under development in places like France to reduce

their dependence on foreign oil.

d. only useful for extracting oil and gas deposits relatively close to the surface.



15. Which of the following regarding trends in manufacturing is true?

a. The value of manufacturing output has remained fairly constant since 1960.

b. The U.S. demand for manufacturing goods increased by 257% between 1980 and

2016, after adjusting for inflation.

c. Manufacturing productivity increased by around 4.7% between 2000 and 2007,

and has fallen to an average of about 1.6% since then.

d. All of the above

e. B and C only

16. Which of the following explanations for the decline in employment in U.S.

manufacturing is true?

a. Americans are demanding fewer manufactured goods.

b. Americans are demanding more manufactured goods produced abroad.

c. Advances in productivity have enabled more output to be produced by fewer workers.

d. All of the above

e. B and C only

17. What factor helped boost employment in U.S. automobile manufacturing, after the

employment decline in the 1970s?

a. Foreign producers have a cost disadvantage of shipping their products to the U.S.

b. The greater productivity of skilled workers enabled U.S. workers to compete

against lower skilled low wage workers abroad.

c. Foreign companies increasingly located production facilities in the U.S.

d. Falling gas prices after the 1970s oil price shocks shifted demand back to larger

U.S. made vehicles.


18. Which of the following about the service sector is false?

a. The average pay of service sector jobs is less than the average pay of

manufacturing jobs.

b. Trade in services is expanding rapidly, and increased more rapidly than trade in

goods between 1995 and 2014.

c. Service sector jobs are more homogenous than jobs in manufacturing.

d. The U.S. currently exports more services than it imports.



19. Which of the following services is a U.S. export?

a. A U.S. citizen uses the financial services of a bank in Switzerland.

b. A German tourist comes to Disneyland for summer entertainment.

c. An American student studies abroad at a British university.

d. An American obtains medical attention in Mexico for a lower price than

attainable in the U.S.


20. Which of the following is not a financial asset as identified in the chapter?

a. Stocks

b. Bonds

c. Foreign currencies

d. Certificates of deposit

e. All of these are identified as financial assets in the chapter.



1. primary

2. primary, secondary

3. secondary

4. tertiary

5. service

6. tertiary

7. five, twenty

8. solar, wind

9. financial

10. tertiary

11. False. It would fall under the primary sector.

12. False. They are generally sold as inputs to manufacturers.

13. False. The primary sector still plays an important role in the economy.

14. True.

15. True.

16. The primary sector involves the extraction and simple processing of raw materials

which are sold as inputs into the production process. The secondary sector

transforms these inputs into final products to consumers. The tertiary sector

involves the provision of services, rather than tangible goods.

17. While the tertiary sector’s share of the private economy has grown over the last

decades of the 20th

century, both the primary and secondary sectors have

declined.

18. Since the 1960s, employment in the secondary sector started to decline, as

employment in the primary sector continued its decline. Employment in the

tertiary sector increased.

19. Primarily it has been due to technological improvements and the rise in agricultural

productivity, which has allowed the products of the primary sector to be obtained with

fewer workers.

20. The threats include: the depletion of groundwater supplies, and soil depletion.

21. Much of the processing of food is a manufacturing activity in the secondary sector.

The marketing, retailing, and provisioning of food in restaurants are service sector

activities in the tertiary sector.

22. One of the key factors contributing to the increase in U.S. energy production since

2012 is the introduction of novel extraction techniques such as hydraulic fracturing

(fracking).

23. The U.S. manufacturing sector is losing jobs for two reasons: manufactured products

can be produced more cheaply abroad, and productivity advances (automation) are

reducing the overall employment in manufacturing.

24. Yes, on average the pay of service sector jobs are lower than manufacturing, for

instance. However, some service sector workers (such as doctors and lawyers) are

paid very well.

25. The four categories are: ownership transactions (e.g. homeownership and activities

involved in ownership transfers such as: transportation, warehousing, wholesale and


retail trade, and real-estate rental and leasing), information and management

(information, finance and insurance, and professional, scientific, and technical

services, administration, waste management and management of companies.), private

social services (education, health care, and social services), and entertainment (which

includes arts, entertainment, recreation, accommodation and food services).

26. As our economy has become so much more complex, the service sector has grown to

organize and manage this huge complex system, e.g. making connections between

buyers and sellers, collect and processing information, etc.

Answers to Problems

1.

a. For the Primary sector:


dollars)

Percent of GDP

Agriculture 21 5.3

Primary Sector Total 21 5.3%

b. For the Secondary sector:


dollars)

Percent of GDP



Secondary Sector Total 109 27.3%

c. For the Tertiary sector:


dollars)

Percent of GDP


Trade 50 12.5


assistance

21 5.3

Education 20 5


Diplomacy & peacekeeping 80 20



54 13.5

Tertiary Sector Total 270 67.6%

2. Now the primary sector is 5.6% of GDP, the secondary sector is 29%, and the

tertiary sector is 64.5%. The tertiary sector has declined while the primary and


secondary sectors have increased in size (as percent of GDP).

3.

a. Supply shifts left; the oil price rises.

b. Demand shifts left; the oil price falls.

c. Supply shifts right; the oil price falls.

d. Demand shifts right; the oil price rises.

e. Demand shifts right; the oil price rises.

f. Supply shifts left; the oil price rises.


1. A

2. D

3. E

4. C

5. E

6. C

7. B

8. C

9. D

10. C

11. E

12. D

13. D

14. E

15. D

16. E

17. E

18. C

19. B

20. E

Chapter 8 – Employment and Unemployment 1

Chapter 8

EMPLOYMENT, UNEMPLOYMENT, AND WAGES Macroeconomics in Context (Goodwin et al.), 3rd edition

Chapter Overview This chapter introduces you to standard macro labor topics such the definition of the

unemployment rate, the different types of unemployment, and theories of the causes of

unemployment. You will learn about labor market institutions and aggregate demand

issues. The final section discusses the future of work based on the changing structure of

the labor market due to technological advances, increased flexibility for workers and

employers, and the rise of “dual labor markets” wherein the lucky few have well-paying

jobs, while the rest are employed in jobs with little security. After reading and reviewing this chapter, the student should be able to:

1. Explain how employment and unemployment are officially measured.

2. Explain why some analysts prefer measures of labor force utilization that differ from

the official unemployment rate.

3. Understand economists’ notions of frictional, structural, and cyclical unemployment.

4. Describe the classical theory of unemployment.

5. Describe alternative theories of labor market including “sticky-wage” theories,

efficiency wage theory, and the dual labor market theory.

6. Describe the various policy responses to address unemployment.

7. Describe the role of technological change in determining the current and future

employment levels.

8. Discuss the impacts of the changing labor market structures, such as the organization

and management of work and increasing flexibility in the labor market, on the future

of work.

Key Terms

Bureau of Labor Statistics (BLS)

civilian noninstitutional population

employed person

unemployed person

labor force

“not in the labor force”

unemployment rate

marginally attached workers

discouraged workers

underemployment

labor force participation rate

frictional unemployment

cyclical unemployment

recession

structural unemployment

technological unemployment

full employment

“sticky wage” theories

efficiency wage theory

dual labor market theory

aggregate demand


Active Review Fill in the Blank 1. The U.S. agency that collects data on employment and unemployment is the . 2. Joe performed 15 hours of unpaid work on his family farm. He would be considered to

be an ____________ person, according to the BLS. 3. Bill lost his job as an airline mechanic, and has been sending out his resume to other

potential employers. He would be willing to start working in a new job immediately. Bill

would be counted as an _______________ person, according to the BLS.

4. Rachael says she wants to work and is available for work. She has recently looked for work but is currently not doing so. The BLS would call Rachael a ____________worker. If she gives as her reason that she is no longer looking for work because there are no jobs for her, she would be considered a ____________ worker. 5. The unemployment that arises due to transitions between jobs is called

__________________ unemployment, whereas the unemployment that arises due to skills

mismatches or geographic mismatches is called _________________unemployment. 6. The theories developed by Keynesian-oriented economists explaining why wages may

remain above equilibrium even when there’s a surplus of labor are called ______________

theories.

7. People working at jobs that underutilize their abilities, as well as those who work fewer

hours than they wish to, are said to be _________________.

8. Paying your workers higher than the market wage rate in order to improve productivity is

an example of ___________ theory.

9. ______________________ is unemployment due to macroeconomic fluctuations.

10. According to the _________________theory, workers get slotted into either a primary

sector of good jobs, or a secondary sector where workers are taken on an “as needed” basis.

True or False 11. The unemployment rate is the percentage of the population that does not have paid employment, but is immediately available and actively looking for work. 12. Almost all of the people who are unemployed are so because they have

involuntarily lost their jobs.

13. Structural unemployment arises because people’s skills, experience, education, or


location do not match what employers need. 14. The peak level of unemployment following the 1981-1982 recession was higher than

the peak level of unemployment following the Great Recession of 2007-2009.

15. Jake is applying for jobs in medical research, while also working as a bartender few

times a week. The BLS counts him as being underemployed.

Short Answer 16. Why is high unemployment considered a bad thing?

17. Describe the two surveys the BLS uses to gather unemployment data.

18. How does the BLS classify people who are “not in the labor force,” and what

people are often in this category? 19. Why is it often said that the official unemployment rate tends to underestimate the true

extent of unemployment in the economy? 20. What are the three major types of unemployment? Which of these three types of

unemployment tends to be spread broadly throughout the entire economy, as occurs as a

result of a drop-off in aggregate demand?

21. What is the classical model’s explanation for involuntary unemployment?

22. Identify two theories that explain why wages might be “sticky” at a higher than

market equilibrium level.

23. Describe Keynes’s theory of aggregate demand, as it relates to wage levels and

employment. Did Keynes believe that unemployment is caused by “sticky wages”? 24. The chapter describes flexibility in the labor market for the workers and for the

employers. Explain these in detail. What kinds of flexibility might workers benefit

from?


Problems 1. The U.S. labor force as of December 2016 was 159.7 million. There were 152.2

million employed, and 7.5 million unemployed. There were about 1.51 million in

prison.

a. Calculate the official unemployment rate.

b. If those 1.51 million people were not in prison, but were in the labor force and

unemployed, calculate what the unemployment rate would be. 2. Assume the labor market is represented by the graphs below. Illustrate the following

scenarios, showing the shift in supply or demand for labor, ceteris paribus. On your

graph, identify the new wage, quantities of labor supplied and demanded, and any

unemployment that exists. Note: This question draws on more than the graphs actually

shown in Chapter 8. You will need to draw on some concepts from Chapter 4 (Supply

and Demand). a. As the economy goes into recession, the demand for labor falls. Illustrate according to the classical model with smoothly functioning labor markets.


b. As the economy goes into recession, the demand for labor falls. Illustrate according

to the Classical-Keynesian synthesis with sticky wages.

Self Test

1. Which of the following is a problem associated with high unemployment?

a. underutilization of national resources

b. loss of income

c. depression, suicide, and domestic violence

d. social unrest and loss of social cohesion

e. all of the above

2. The labor force participation rate is

a. the number of people in the labor force divided by the population

b. the number of people in the labor force divided by the civilian,

noninstitutionalized age 16 and over population

c. the number of people in the noninstitutionalized age 16 and over population

divided by the labor force.

d. the number of unemployed divided by the labor force

e. the number of unemployed divided by the civilian, noninstitutionalized age 16

and over population


3. To be considered employed by the BLS, you need to

a. have worked for pay or profit at least 10 hours per week. b. have worked for pay or profit at least 10 hours per week, or unpaid in a

family-run business for at least 15 hours a week. c. have worked for pay or profit for at least one hour per week. d. have worked for pay or profit for at least one hour per week, or unpaid in a

family-run business for at least 15 hours a week.

e. be registered at an employment agency.

4. Nabiha is currently not employed, but is thinking about getting a job and is browsing

through the want ads to see what kinds of jobs are available. The BLS would consider

Nabiha to be:

a. unemployed

b. in the labor force c. not in the labor force d. a discouraged worker e. none of the above

5. Rebecca lost her real estate agent job after the housing bubble burst, and after several

months of an unsuccessful job search, she has stopped looking and entered a job

retraining program to become a nurse. The BLS would currently count Rebecca as:

a. employed

b. unemployed

c. in the labor force

d. not in the labor force

e. seasonally unemployed

6. Assume a very small economy comprised of the following people, all of whom are

civilians, 16 years and older. Amir is happily employed. Bert does not have work, but is

actively sending out his resume to employers. Miguel has not had work for quite a while,

and occasionally flips through job ads to see what kinds of jobs are available. Marlena has

just graduated from college and is starting her job search. Marijka has left her job to care

for her newborn child. The labor force participation rate in this economy would be:

a. 20%

b. 40%

c. 60%

d. 80%

e. 100%


7. Suppose the population is 300 million. There are 146 million employed, and 7.2 million unemployed. Then the unemployment rate is:

a. 2.4% b. 4.7% c. 4.9% d. 5.3% e. There’s insufficient data to determine the unemployment rate.

8. Suppose the population is 300 million. There are 146 million employed, and 7.2 million

unemployed. Suppose that 1 million of the 7.2 million unemployed become so

discouraged that they drop out of the labor force. The unemployment rate is:

a. 2.1%

b. 2.4%

c. 4.1%

d. 4.7%

e. There's insufficient data to determine the unemployment rate.

9. Which of the following groups has not historically and consistently experienced

unemployment rates significantly higher than the average worker?

a. African Americans b. Hispanics and Latinos c. Teenagers d. People with less than a high school diploma e. Women

10. Fernando lost his job as a computer programmer during the last recession, and could only

find part-time work for a couple hours a week at lower pay as a grocery store cashier.

Fernando is:

a. unemployed

b. underemployed c. a discouraged worker d. not in the labor force e. a marginally attached worker

11. Khaled used to work as an autoworker, and due to the decline of the U.S. auto

industry, is now unemployed and thinking about retraining as a bicycle assembler.

What type of unemployment is he experiencing?

a. frictional unemployment

b. structural unemployment

c. cyclical unemployment

d. natural unemployment

e. seasonal unemployment


12. Prasad lost his job during the last recession. What type of unemployment is he

experiencing?






13. After raising two children, Mona has started looking for a job and sent out a few job applications. What type of unemployment is she experiencing?




d. natural unemployment e. Mona would not be counted as unemployed as she is not in the labor force.

14. Kimberly has finally had enough of her supervisor’s incompetence. She just left her job

feeling confident that she will have little difficulty finding another paid position using her

skills which are in great demand right now. What type of unemployment is she

experiencing?






15. Jolly works as a department store Santa Claus. As Christmas day comes to a close he finds

himself out of work yet again. What type of unemployment is he experiencing?







16. According to the classical model of smoothly functioning labor markets, if the demand for

labor falls, for instance due to a drop in aggregate demand,

a. wages will fall and labor markets will return to full employment equilibrium,

eliminating the surplus of labor.

b. wages will remain unchanged, leading to the persistence of unemployment.

c. wages will remain unchanged, and the supply of labor will drop and thereby

eliminate the surplus of labor (unemployment).

d. wages and the quantity of labor will remain unchanged.


17. Which of the following have been proposed as explanations for sticky wages?

a. psychological resistance to wage cuts

b. minimum wages and long term contracts

c. efficiency wages

d. people receiving higher wages holding out for a long time against other forces

e. all of the above

18. Bob the boss is paying his workers a bit higher than the market going wage, because he

wants them to put in more effort on the job, and to reduce employee turnover. His actions

would be an example of which labor market theory?

a. low-turnover theory

b. efficiency wage theory

c. classical theory

d. unemployment theory


19. The possible benefits of having more democratic work place include …

a. better working conditions and greater bargaining power for workers

b. more equal distribution of work and income levels among the workers

c. increased productivity and motivation for workers

d. All of the above


20. Which of the following is not an element of the Keynesian critique of the classical model?

a. unemployment is NOT due to wages being “too high.”

b. faith in market forces will be rewarded with a tendency towards full employment.

c. an emphasis on aggregate demand is important for macroeconomic

analysis.

d. government policies can be an effective response to economic downturns.

e. all of these are elements of the Keynesian critique of the classical model.



1. Bureau of Labor Statistics (BLS)

2. employed

3. unemployed

4. marginally attached, discouraged

5. frictional, structural

6. sticky wage

7. underemployed

8. efficiency wage

9. cyclical unemployment

10. dual labor market

11. False. It is not the percentage of the population, but the percentage of the labor force who do not have paid jobs but are immediately available and actively looking for work.

12. False. Only on average about half of the unemployed have involuntarily lost their jobs. Others have voluntarily quit, or are just entering the labor force, or re-entering it.

13. True.

14. True.

15. False. While Jake is underemployed because of underutilization of his skills, he is

counted as being employed by the BLS.

16. High unemployment means that a nation’s resources are being underutilized. It also

poses great economic, psychological, and social costs on unemployed individuals, as

well as their families and their communities. It is associated with higher rates of

depression, suicide, domestic violence, and lack of social cohesion.

17. The household survey questions 60,000 households on a monthly basis, asking whether

the individual household members are working or not, and if not, if they are looking for

work. The employer survey collects employment data from 400,000 employers.

18. If an individual surveyed (that is, who is age 16 or over and not institutionalized) is

neither employed nor unemployed, that individual is considered “not in the labor force”

according to the BLS. Often people in this category are in school, retired, disabled, or

taking care of people in their households and communities.

19. Because discouraged workers and underemployed workers (involuntary part-time or

workers not making use of their skills) are not counted among the unemployed in the

official unemployment statistic.

20. Frictional, structural, and cyclical unemployment. Cyclical unemployment is broadly

spread through an economy during a downturn.

21. According to the classical model, involuntary unemployment only arises when there is something impeding market forces, like a minimum wage law, public safety net policies, regulations on business, or union activity.


22. Efficiency wage theory and dual labor market theory.

23. For Keynes, the problem with a drop in the demand for labor was not that wages would

get stuck at a rate too high and fail to drop to a lower equilibrium rate, but that a drop in

the wage would make the unemployment problem even worse. As workers experienced

lower wages, they would cut back on spending, which lead to a drop in aggregate

demand and output.

24. Flexibility for workers includes job sharing, having more flexible work hours or being

able to work remotely. Workers could benefit from such work arrangements.

Participating in the gig economy, where workers work under short-term contracts or

work when the want to and are needed, also provides some flexibility to the workers—

though many workers may be taking up such work only because they cannot find

“regular” jobs. Flexibility for employers involves firms having greater power over

hiring and firing workers and being able to hire workers on “as needed” basis and with

little job protection.

Answers to Problems

1. a. 4.7% b. 5.6%

2. a.

The equilibrium wage drops to W2. The new quantity supplied and quantity demanded are equal, at L2. There is an equilibrium situation, with no unemployment.


b.

The wage, being “sticky,” stays at W*, its original level. The quantity of labor

demanded drops to LD, while the quantity of labor supplied remains at LS. There is

unemployment, as shown by the shaded difference between LS and LD on the graph.


1. E

2. B

3. D

4. C

5. D

6. C

7. B 8. C

9. E

10. B

11. B

12. C

13. A

14. A

15. E

16. A

17. E

18. B

19. D

20. B

Chapter 9 – Aggregate Demand and Economic Fluctuations 1

Chapter 9

AGGREGATE DEMAND AND ECONOMIC FLUCTUATIONS Macroeconomics in Context (Goodwin, et al.)

Chapter Overview

This chapter first introduces the analysis of business cycles, and introduces you to the

two stylized facts of the business cycle. The chapter then presents the Classical theory of

savings-investment balance through the market for loanable funds. Next, the Keynesian

aggregate demand analysis in the form of the traditional "Keynesian Cross" diagram is

developed. You will learn what happens when there’s an unexpected fall in spending, and

the role of the multiplier in moving to a new equilibrium.

Chapter Objectives


1. Describe how unemployment and inflation are thought to normally behave over the

business cycle.

2. Model consumption and investment, the components of aggregate demand in the

simple model.

3. Describe the problem that “leakages” present for maintaining aggregate

demand, and the classical and Keynesian approaches to leakages.

4. Understand how the equilibrium levels of income, consumption, investment, and

savings are determined in the Keynesian model, as presented in equations and

graphs.

5. Explain how, in the Keynesian model, the macroeconomy can equilibrate at a

less-than-full-employment output level.

6. Describe the workings of “the multiplier,” in words and equations.

Key Terms

Okun’s “law” behavioral equation

“full-employment output” (Y*) marginal propensity to consume

aggregate expenditure (AE) marginal propensity to save

accounting identity paradox of thrift


Active Review Fill in the Blank

1. The macroeconomic goal that involves keeping the rate of unemployment and

inflation at acceptable levels over the business cycle is the goal of .

2. The _________ economists believe that aggregate expenditure needs active guidance,

whereas the ___________ economists believe that aggregate expenditure can take care

of itself.

3. The recurrent fluctuations in the level of national production is called the . 4. When economic activity declines, usually measured by a fall of real GDP for two

consecutive quarters, the economy is said to be in a . 5. The equation that expresses the inverse relationship between the unemployment rate

and the rapid growth of real GDP is known as . 6. The level of output that occurs when the economy is not suffering from an

unemployment problem (that is, when any unemployment that exists is just transitory), is

called output. 7. In the traditional macro model (with no government or foreign sector), what households

and firms intend to spend on consumption and investment is called ____________.

8. The equation AE = C + II is a(n) __________, because it reflects a theory about the behavior of one or more economic agents or sectors. The equation Y = C + I is a(n) ___________, because it represents the actual level of aggregate spending that in fact occurs. 9. In the Keynesian consumption function, C = C + mpc Y, C represents _______, the mpc is the __________, and Y represents __________. 10. The ________ is the portion of every dollar of aggregate income that is saved, and can be expressed as ∆S/∆Y.

11. The formula 1/(1-mpc) is the formula for the “income/spending __________” in a

simple closed economy with no government.

True or False

12. The two “stylized facts” of the business cycle are always corroborated by the historical

evidence. 13. According to Okun’s Law, as originally formulated in the early 1960s, a 1% drop in

the unemployment rate is associated with an approximately 3% increase in real GDP.

14. Y = AE only when actual investment equals intended investment.


15. In a situation with insufficient aggregate expenditure, C + II < C + I 16. According to the classical economists, a sudden fall in investment spending would

cause a fall in the interest rate, and the lower interest rate would then stimulate

investment spending again and return it to its original level.

Short Answer

17. Explain the two “stylized facts” of the business cycle. 18. What was the response to the Great Depression of economists trained in the classical

school? 19. Explain the difference between the behavioral equation AE = C + II, and the

accounting identity Y = C + I (in a simplified economy with no government or foreign

sector). 20. Given the following Figure below (Figure 9.8 in your textbook), explain what the

classical school predicts will happen when there is a sudden drop in intended investment

spending.

21. What are the determinants of investment spending in the Keynesian model, and

which factor plays the most important role (especially in a recession)?

22. In the Keynesian model, what happens to investment and inventories when there is

insufficient aggregate expenditure?


23. In the figure below:

a. What is this diagram called?

b. What does the 45 degree line represent?

c. At an income level of 800, what is the level of spending? Is there any unintended

investment? If so, what will be the response of producers? 24. In the figure in the above question, if 800 represents full employment output, would

the equilibrium where income = 400 be desirable? Is there unemployment at this

equilibrium? And according to Keynes, would there be forces automatically moving the

economy back to the full employment output level? 25. Explain what is meant by “the multiplier,” and describe it in words.

26. (In appendix): What are the basic steps to deriving the multiplier algebraically?


Problems

1. Given this graph of real GDP for the U.S. in the years 1960 – 2015:

Source: www.bea.gov Identify approximately what years the economy went into a recession.

2. Use the graph below to answer the following questions:

a. Label the phases of the “stylized” business cycle graph.

A:

B:

C:

D:

0

3000

6000

9000

12000

15000

18000

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

GD

P (

Bill

ion

s o

f C

on

stan

t 2

01

0

USD

)

U.S. Real GDP

http://www.bea.gov/


b. What does Y* refer to?

3. Use the table below (for a simple economy with no foreign sector or government) to

answer the questions that follow.

(1)

Income

(Y)

(2)

Consumption

(C)

(3)

Intended

Investment

(II)

(4)

Aggregate Expenditure

AE = C + II

= column (2) + column (3)

0 30 (a) 50

300 300 20 (b)

400 (c) 20 410

500 480 20 500

600 (d) 20 (e)

Fill in the missing numbers in the spaces marked (a)-(c).

Determine the consumption function, and use the result to fill in the remaining missing

numbers (d)-(e).

(f) Determine the equilibrium output level.

4. Use the Keynesian cross diagram, and illustrate how the AE would shift in each

scenario. Indicate whether the economy would end up at a higher or lower equilibrium

output.

a. Households experience a decline in wealth as the value of housing drops when the

housing bubble bursts.

b. The nation’s leaders tell consumers it is their patriotic duty to save the economy by

consuming more, and consumers do so

c. The same national leaders pass policies favoring the wealthy, which leads to a more

unequal distribution of income.


5.

a. Assume a simple, closed economy with no government. The marginal propensity to

consume (mpc) = 0.8. Assume that firms expect the future sales and profits to fall, and

they suddenly cut back (unintended) investment spending (II) by 50 million. By how

much will output eventually fall?

b. Now assume the same as above, except that now the mpc = 0.9. How much will

output fall when unintended investment spending drops by 50 million?

Self Test

1. Keeping the economy balanced with acceptable levels of unemployment and inflation

is the key aspect of the goal of:

a. growth in living standards

b. stabilization

c. sustainability

d. trade expansion

e. equal income distribution

2. Two stylized facts of the business cycle are that:

a. during an economic contraction, unemployment falls and inflation rises, while

during an expansion, unemployment rises and inflation falls.

b. during an economic contraction, unemployment rises and inflation falls, while

during an expansion, unemployment falls and inflation rises.

c. during an economic contraction, both unemployment and inflation fall, while

during an expansion, both unemployment and inflation rise.

d. during an economic contraction, both unemployment and inflation rise, while

during an expansion, both unemployment and inflation fall.



Refer to the Figure below for the next two questions.

3. When is inflation and unemployment most likely to be a problem?

a. Inflation and unemployment will be a problem in the grey area representing the

range of full employment output.

b. Inflation will be a problem during the peak of an expansion, and

unemployment will be a problem during the trough of the contraction.

c. Inflation will be a problem during the trough of the contraction, and

unemployment will be a problem during the peak of the expansion.

d. Inflation will be a problem during both the peak and the trough of the business

cycle.

e. Unemployment will be a problem during both the peak and trough of the

business cycle.

4. What is the goal of stabilization policy?

a. To keep the economy as close to the peak as possible, where unemployment

remains very low.

b. To keep the economy as close to the trough as possible, where inflation

remains low.

c. To keep the economy in the grey area, to avoid the threats of both excessive

unemployment and inflation.

d. To enable the economy to move freely from peak to trough.



5. Which of the following best describes the meaning of aggregate expenditure in

the traditional macro model (with no government and a closed economy)?

a. The amount firms and households intend to spend on consumption and

investment.

b. The actual level of spending done in the economy by firms and households on

consumption and investment.

c. The summing up of all the spending on goods and services in the economy by

firms and households.

d. The average level of demand for all goods and services in the economy by


e. The average level of spending on all goods and services in the economy by


6. According to the simplified macro model (with no government and no foreign sector),

which of the following characterizes an economy in equilibrium?

a. When leakages = injections

b. When saving (S) = intended investment (II)

c. When Y = AE

d. When actual consumption and investment spending equals the intended

consumption and investment spending.

e. All of the above

7. In the classical model:

a. flexible markets will keep the economy at a full-employment level of spending

and output.

b. both households’ saving activity and firms’ investment activity are quite

sensitive to changes in the interest rate.

c. adjustments in the interest rates quickly correct any imbalances between saving

and investment.

d. a sudden fall in investment spending would cause a fall in the interest rate,

which would dampen saving and stimulate consumption, quickly returning the

economy to full employment.

e. all of the above.

8. Which of the following can describe the meaning of autonomous consumption?

a. The part of consumption that is not related to income.

b. That which, when it changes, shifts the consumption schedule up or down.

c. A minimum level of income that people feel required to spend for survival. d.

The amount of consumption spending people will undertake no matter what

their current incomes are, reflecting their long-term plans, their commitments and

habits, and their place in the community.



9. The marginal propensity to consume (mpc):

a. stands for the portion of every additional dollar of aggregate income that goes

to consumption spending.

b. is equal to the change in consumption (C) divided by the change in aggregate

income (Y).

c. is equal to 1 – mps. d. theoretically should be less than 1

e. all of the above.

Use the Figure below to answer the next two questions:

10. In the figure above, what is the level of autonomous consumption?

a. 0

b. 20

c. 100

d. 340

e. 400

11. In the figure above, when income = 400, what is the level of saving?

a. 400

b. 340

c. 60

d. 20

e. 0


12. Which of the following factors will not cause a shift in the consumption function (or

schedule)?

a. Wealth

b. Consumer confidence

c. Cultural attitudes toward spending and saving

d. A change in income

e. Changes in the distribution of income

13. In the Keynesian model:

a. Households only save and lend, and do not borrow.

b. Consumption spending is more sensitive to the interest rate than to income.

c. Investment spending, especially in a recession, is highly sensitive to the interest rate.

d. Investment spending is highly sensitive to investors’ confidence and

expectations of future sales and profits (or “animal spirits”).

e. All of the above

14. Which of the following will not cause a shift in the investment function (or schedule)

in the Keynesian model?

a. A change in investors’ confidence and expectations of the future

b. A change in the interest rate

c. A change in household disposable income

d. A change in prices of investment goods

e. A change in the willingness of lenders to lend

15. If aggregate expenditure falls below aggregate output (AE<Y), according to the

Keynesian model, what happens to unintended inventories?

a. There is a depletion of unintended inventories.

b. There is an accumulation of unintended inventories.

c. Unintended inventories remain unchanged.

d. Unintended inventories fall to zero (0).


16. Unlike the Classical economists, Keynes thought that after a sudden fall in investment

spending:

a. the economy would quickly return to full-employment equilibrium.

b. the economy could contract by even more than the initial fall in spending, and get

stuck there.

c. the market mechanism would automatically pull an economy out of a

recession.

d. a rise in consumption spending would counteract the fall in investment

spending, keeping the economy at full employment.



17. Which of the following expresses the value of the income/spending multiplier (in a

simple closed economy with no government)?

a. 1/mpc

b. 1/(1+mpc)

c. 1/(1-mpc)

d. 1+mpc

e. 1-mpc

18. Assume a simple, closed economy with no government. The marginal propensity to

consume (mpc) = 0.75. Then the value of the multiplier is:

a. 1.34

b. 0.57

c. 4

d. 1.75

e. 0.25

19. Which of the following best describes the relationship between the mpc and the

multiplier?

a. The higher the mpc, the higher the multiplier.

b. The higher the mpc, the lower the multiplier.

c. The lower the mpc, the higher the multiplier.

d. There is no relationship between the mpc and the multiplier.

e. There is a one to one relationship between the mpc and the multiplier – the

multiplier will increase by the same amount as the increase in the mpc.

20. Assume a simple, closed economy with no government. The marginal propensity to

consume (mpc) = 0.8. Assume there’s a sudden drop in investment spending by 100

million. By how much will output eventually fall?

a. 20 million

b. 100 million

c. 125 million

d. 500 million




1. stabilization

2. Keynesian, classical

3. business cycle

4. recession

5. Okun’s “Law”

6. full employment output

7. aggregate expenditure

8. behavioral equation, accounting identity

9. autonomous consumption, the marginal propensity to consume, aggregate income.

10. the marginal propensity to save

11. multiplier

12. False. The two stylized facts are not always true. There are periods when the

economy has gone into recession and the inflation rate has increased. And there

are periods when the economy has gone into an expansion, and the inflation rate

has not increased.

13. True.

14. True.

15. True

16. False. The lower interest rate would primarily dampen saving and stimulate

consumption spending, and the economy would return to equilibrium with a

higher composition of consumption spending and less investment spending than

before.

17. As GDP falls during a contraction, unemployment rises because producers are

producing less goods and services and need fewer workers. And during an expansion,

producers need more workers as they increase production, so the unemployment rate

falls (stylized fact #1). As producers increase their production, however, there’s more

competition for the limited supply of workers and other inputs, which bids up wages

and prices and results in an increase in the rate of inflation. Whereas during an

economic contraction, there’s less pressure on wages and prices and the rate of

inflation slows down or becomes negative (stylized fact #2).

18. Classical economists thought that the economy would recover by itself, so there was

no need for the government to intervene.

19. The behavioral equation AE = C + II expresses the spending intentions by firms and

households. They may not actually spend the amount that they intended to. The

accounting identity Y = C + I expresses the actually spending that has occurred

(which can be tallied up in the national accounts and is theoretically equal to GDP –

at least in the simplified economy with no government or foreign sector).

20. A sudden fall in investment spending would cause a fall in the interest rate, which

would dampen saving and stimulate consumption, quickly returning the economy to

full employment. The full employment level will now have somewhat more

consumption spending and less investment spending.

21. The determinants of investment spending are: the interest rate, prices of investment

goods, accumulated assets and debt, the willingness of lenders to lend, but most

important for Keynes was the level of confidence and expectations about the future.

22. When there’s insufficient aggregate expenditure, there will be unintended investment

and excess inventory accumulation.


23. a. The diagram is called the Keynesian cross diagram.

b. The 45 degree line represents where output = income.

c. At an income of 800, spending equals 720, so spending is less than income (AE <

Y), and there’s unintended investment (i.e. inventory accumulation) of 80. Producers

will cut back production, so income, consumption and saving all drop, and the

economy will eventually move to the equilibrium at 400, where AE = Y.

24. The equilibrium would not be a desirable one, as there is persistent unemployment

there (of the cyclical kind). Unlike the classicals, Keynes thought the economy could

get stuck at an equilibrium below the full employment output, and there would be no

forces that would automatically move the economy back to full employment output.

25. When spending drops by a certain amount, output drops by more than that amount,

i.e. by a multiplied amount. This is because the drop in spending has a feedback or

echo effect on the economy. As firms cut back production and lay off workers, those

workers now have a lower income, and cut back their own consumption. This affects

additional firms, who see their inventories pile up and cut back production. Thus

more workers are laid off and incomes fall further, leading to a vicious circle of higher

unemployment, lower income, and lower investment.

26. To solve the multiplier algebraically, first substitute the consumption function into

the equation for AE (AE = C+II). Then set Y=AE, and solve for Y.

Answers to Problems

1. It appears the U.S. economy went into recession in the years 1973-75, 1979-80, 1981-

82, 1990-91, and 2007-9, because these are the periods when it the level of real GDP

actually goes down. (There was also a relatively mild recession during 2001, which is not

apparent except as a slight flattening on the GDP per capita graph, since it occurred

entirely within 2001; by 2002 GDP was growing once again).

2.

A: contraction

B: expansion

C: peak

D: trough

Y*: full employment output

3.

(1)

Income

(Y)

(2)

Consumption

(C)

(3)

Intended

Investment

(II)

(4)

Aggregate Expenditure

AE = C + II

= column (2) + column (3)

0 30 20 50

300 300 20 320

400 390 20 410

500 480 20 500

600 570 20 590


Using AD = C + II,

(a) 50 = 30 + 20

(b) 320 = 300 + 20

(c) 410 = 390 + 20

Deriving the consumption function:

Autonomous consumption = 30 (from the first row where Y = 0).

To find the mpc, calculate a change in C (e.g. 390 – 300 = 90), and divide by the

corresponding change in Y (400 – 300 = 100). So the mpc = ∆C/∆Y = 90/100 = 0.9

Hence, the consumption function is C = 30 + 0.9Y

To fill in (d), C = 30 + .9(600) = 30 + 540 = 570.

(e) follows from 590 = 570 + 20. f. Equilibrium is where Y = AD, which is at 500

(see shaded row).

4.

a. Households experience a decline in wealth as the value of housing drops when the

housing bubble bursts: AE would shift down, and the new equilibrium would be at a

lower level of output.

b. The nation’s leaders tell consumers it is their patriotic duty to save the economy by

consuming more: If consumers act on this, AE would shift up, and the new equilibrium

would be at a higher level of output.

Agg

rega

te E

xpen

dit

ure

an

d O

utp

ut

AE1

AE2


c. The same national leaders pass policies favoring the wealthy, which leads to a more

unequal distribution of income: Since the rich tend to have much lower marginal

propensity to consume than the poor, a greater share of income going to the rich would

lower overall consumption levels and increase savings. Hence, AE would shift down and

the new equilibrium would be at a lower level of output. The graph would look like the

one in part a above.

5 a. Since the marginal propensity to consume (mpc) = 0.8, the multiplier = 5. With a ∆II

of 50 million, using the formula:

∆Y = mult ∆II

∆Y = 5 × 50 million

∆Y = 250 million

b. Now with an mpc = 0.9, the multiplier = 10. With a ∆II of 50 million,

∆Y = mult ∆II


∆Y = 500 million.


1. B

2. B

3. B

4. C

5. A

6. E

7. E

8. E

9. E

10. B

11. C

12. D

13. D

14. C

15. B

16. B

17. C

18. C

19. A

20. D

AE2

AE1 A

ggre

gate

Exp

end

itu

re a

nd

Ou

tpu

t AE1

Chapter 10 – Fiscal Policy 1

Chapter 10

FISCAL POLICY Macroeconomics in Context, 3rd edition (Goodwin, et al.)

Chapter Overview This chapter introduces you to a formal analysis of fiscal policy, and puts it in context

with real-world data and examples. The basic analysis you will be presented here follows

the Keynesian model, although you will also learn about the “classical” or “supply-side”

perspectives. You will gain an understanding of the federal budgets and how it affects the

economy. The chapter clarifies the difference between automatic stabilizers and

discretionary policy, and discusses recent fiscal policies in terms of their economic

impact. Finally, the chapter introduces "crowding out" and "crowding in" and explores the

macroeconomic implications of each of these two concepts.

Chapter Objectives After reading and reviewing this chapter, you should be able to:

1. Understand the impact of changes in government spending, taxes, and transfers

on aggregate expenditure and output.

2. Carry out calculations using “multipliers.”

3. Describe the major types of government outlays, and major government

revenue sources.

4. Discuss the issue of lags in fiscal policy, and the relative advantages and

disadvantages of automatic and discretionary policies.

5. Distinguish between cyclical deficits and structural deficits.

6. Explain the macroeconomic policy implications of both crowding out and

crowding in.

Key Terms

fiscal policy on-budget expenditures

government spending (G) appropriation (of federal funds)

transfer payments budget surplus

disposable income budget deficit

tax multiplier deficit spending

balanced budget multiplier countercyclical policy

net taxes procyclical policy

expansionary fiscal policy automatic stabilizers

contractionary fiscal policy cyclical deficit (surplus)

government outlays discretionary fiscal policy

government bond time lags

off-budget expenditures structural deficit (surplus)

supply-side economics crowding in

crowding out


Active Review

Fill in the Blank

1. If the government uses tax cuts to expand the economy, it would be using

policy

2. Social security payments that are paid by the government to households are an

example of a .

3. Suppose a household receives a wage income of $4,000 a month, and receives $400 in

transfers and pays $800 in taxes per month. Then the household’s income

(the income after paying taxes and receiving transfers) would be equal to $3,600 per

month.

4. To determine the impact on a change in lump sum taxes on equilibrium output, one

would use the tax multiplier, which equals .

5. If one were to increase government spending by $50 million, and simultaneously raise

taxes by $50 million in order to keep the government budget in balance, one would

discover that the multiplier is equal to positive one.

6. Government spending on goods and services (such as new bridges and mass transit)

and government transfer payments (such as unemployment compensation and food

stamps) are two categories of government .

7. The government can finance its deficits by selling , which are essentially

promises to pay back, with interest, the amount borrowed at a specific time in the

future.

8. The progressive income tax and transfer payments such as unemployment

compensation are examples of , because these tax and spending

institutions increase government revenues and lower government outlays during an

expansion (and decrease government revenues and raise government outlays during a

contraction) thereby smoothing out the business cycle.

9. Suppose the Congress passes a stimulus package, but it takes time for recipients of the

stimulus payments to spend the money. The effect may not be seen on the wider

economy for a period of time, due to the presence of .

10. The policies that use tax cuts and other incentives in an attempt to increase work,

saving and investment, and thereby overall economic output, are called

economics.


True or False

11. There is no way to expand an economy using fiscal policy without incurring (or

increasing) a budget deficit.

12. With an mpc of 0.8, the multiplier for U.S. government spending is equal to a value

of 5, and this value is a fairly accurate reflection of the multiplier in the real world.

13. A policy tool that can be used to fight inflation (brought about by excessive

aggregate expenditure) is contractionary fiscal policy.

14. If T – (G + TR) is positive, there is a government budget surplus. If T – (G + TR) is

negative, there is a government budget deficit.

15. The existence of budget deficits must mean that the government is conducting an

expansionary fiscal policy.

16. The equation for aggregate expenditure with government in an open economy is: AE

= C + I + G + NX

Short Answer

17. What multiplier is used for calculating the change in output resulting from a change

in government spending? 18. What are the three expansionary fiscal policy tools the government can use to expand

an economy that is in a recession? 19. What are the three ways the government can finance its expenditures?

20. What are the largest two sources of federal revenues? What are the largest three

categories of federal outlays? 21. What role does the size of the economy (GDP) have to play in whether or not a

government deficit is burdensome to the economy?


22. What role did automatic stabilizers and discretionary fiscal policies have in the

emergence of budget surpluses during the late 1990s?

23. Are tax cuts always directed at stimulating aggregate expenditure? Explain why

some supply-siders think tax cuts may actually increase tax revenues.

24. Identify and describe the four types of inside lags as presented in the chapter.

25. Explain the difference between a cyclical deficit and a structural deficit.

26. Explain the difference between "crowding out" and "crowding in." Problems

1. Suppose in a simple economy with no foreign sector, the mpc equals 0.8. Intended

investment spending has suddenly fallen, reducing AE and output to a level that is

100 million below Y*.

a. If the government decided to try to get the economy back to full

employment using only an increase in government spending (∆G), by how

much would G need to be increased?

b. If the government, instead, decided to try to get the economy back to full

employment using only a lump-sum tax cut (∆T), how big of a tax cut

would be needed?

c. Alternatively, if the government decided to try to get the economy back to

full employment using only an increase in transfers (∆TR), how large

would this increase need to be?


d. Which fiscal policy--increasing G, decreasing T, or increasing TR--would do

the least amount of damage to the government budget deficit?

2. Suppose it was found that the mpc varied by income level in the following manner,

with lower income households spending a greater portion of every dollar of income

than higher income households.

Household income mpc Income/spending

multiplier

Tax multiplier

0-$30,000 0.9

$31,000 – 50,000 0.8

$51,000 – 80,000 0.75

$80,000 and above 0.6

a. Calculate the government spending and tax multipliers for each income bracket,

considered separately.

b. Suppose the government decided to use tax cuts to expand the economy, and

was debating whether to direct tax cuts to high income households or low

income households. Which choice would provide a greater stimulus? Thus,

which would do the least amount of damage to the government budget deficit to

achieve a given amount of stimulus?

(Note: Technically, while tax cuts can, by design of the policy, be targeted so that

their initial impact is on the incomes of a particular group, the feedback effects

represented by the multiplier probably in general depend on the economy-wide

average value of the mpc. We abstract from this issue in this question.)


3. Assume a simple closed economy, with an mpc equal to 0.75. The government has

passed a balanced budget amendment. The economy goes into a recession, so the

government increases government spending by 40 million to try to expand the

economy.

a. Calculate the change in output (∆Y) from the increase in government spending

(∆G).

b. The balanced budget amendment requires the government to also raise taxes by

40 million. Calculate the change in output (∆Y) from the tax hike.

c. What is the net effect on output from these two policies? Was there

any expansionary effect?

d. Why is a balanced budget amendment problematic or undesirable? 4. Use the Figure below to answer the following questions:

a. It is sometimes said that Republicans are the party of “small government,”

whereas Democrats are the “big spenders” and the party of “big government.”

Is this confirmed by the historical evidence of the 1975-2017 period?

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

19

75

19

78

19

81

1984

19

87

19

90

19

93

19

96

19

99

20

02

20

05

20

08

20

11

20

14

20

17

Federal Surplus or Deficit (as Percent of GDP), 1975 - 2017

Carter Reagan Bush Sr. Clinton Bush Jr. Obama

Per

cen

t o

f G

DP


b. What changes in discretionary Government outlays (G, TR) and Tax revenues

(T) might explain the emergence of the huge deficits under Reagan, G. Bush Sr.,

and G.W. Bush Jr? And what might explain the surpluses under Clinton?

c. Are changes in discretionary fiscal policy sufficient in explaining the

emergence of deficits and surpluses? What role do automatic stabilizers play?

Consider in your answer the figure of the U.S. real GDP growth rate, below.

d. When Clinton came into office, he increased taxes (the top income bracket was

raised somewhat) and cut government spending. These are both considered to

be contractionary fiscal policies. And yet the economy boomed. What could

explain this? Could the surpluses under his administration come about only

from his discretionary fiscal policies?

e. The G.W. Bush Jr. administration increased government spending and passed

sizeable tax cuts, primarily benefitting the rich. Critics argue that these tax cuts

will only lead to deficits and do little to stimulate the economy. Explain their

point of view.

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

20

13

20

15

20

17

Re

al G

DP

Gro

wth

(%

)


Self Test

1. Fiscal policy refers to ...

a. control of the money supply

b. decisions to alter market interest rates

c. government spending and taxation decisions

d. control of the producer price index

e. none of these

2. Which of the following is not a component of aggregate expenditure?

a. consumption

b. unsold inventories

c. intended investment

d. government spending

e. all of these are components of aggregate expenditure

3. Suppose in a simple economy with no foreign sector, the mpc is equal to 0.75. How

much government spending (∆G) would be needed to raise output by 100 million?

a. 25 million

b. 33.3 million

c. 75 million

d. 400 million


4. Which of the following is not an example of a transfer payment?

a. Welfare payments to firms or individuals

b. Social Security payments

c. Unemployment compensation

d. A corporate tax cut

e. Payments of interest to holders of government bonds.

5. Suppose in a simple economy with no foreign sector, the mpc is equal to 0.9. How

much of a lump sum tax (∆T) would be needed to raise output by 100 million?

a. 10 million

b. 11.1 million

c. 33.3 million

d. 100 million



6. Suppose in a simple economy with no foreign sector, the mpc is equal to 0.8. If the

government increased government spending by $30 million, and it simultaneously

raised taxes by $30 million, how much will be the change in output (∆Y)?

a. Output will increase by $15 million

b. Output will increase by $30 million

c. There will be no change in output

d. Output will decrease by $30 million


7. Government outlays ...

a. are the sum of government spending and government transfer payments.

b. are always greater than government revenues

c. must, by law, exactly equal government revenues

d. are generally less than government revenues

e. none of these

8. Which of the following is not an example of a government outlay?

a. Government spending on a national health care system

b. Government spending on light rail systems and bicycle paths

c. Housing subsidies for low-income households

d. Tax cuts for wind and solar energy producers

e. Child care vouchers for working single parents

9. Which of the following was one of the major sources of federal revenues in 2017?

a. Personal income taxes

b. Corporate income taxes

c. Excise and estate taxes

d. Both A and B


10. Which of the following was the largest category of government spending in 2017?

a. Social programs, such as welfare

b. Defense spending

c. Social security, Medicare, and retirement

d. Net interest on the debt


11. Procyclical policy ...

a. refers to the use of fiscal policy to improve the performance of the U.S. economy

b. refers to state/local governments tendency to exacerbate the business cycle.


c. refers to Federal Reserve policy designed to minimize economic downturns

d. refers to Chamber of Commerce efforts to encourage households to shop locally

e. none of these are descriptions of procyclical policy

12. During what period of time did the U.S. experience federal government budget

surpluses?

a. 1980 – 1988

b. 1989 – 1992

c. 1993 – 1997

d. 1998 – 2001

e. 2002 – 2008

13. Which of the following was responsible for putting the budget back into deficit in

2001?

a. The recession that started in the Spring of 2001.

b. The 2001 Bush tax cuts

c. The increased government spending of the Bush administration.

d. Both A and B.


14. The President drafts a budget proposal with new tax cuts and increases in government

spending, and has it passed by Congress. This would be an example of:

a. Automatic stabilizers

b. Discretionary policy

c. Contractionary fiscal policy

d. Supply side policy


15. Which of the following is not an example of an inside time lag?

a. data lag

b. recognition lag

c. legislative lag

d. transmission lag

e. response lag


16. The Obama Stimulus Program ...

a. is also known as the "American Recovery and Reinvestment Act."

b. added more than three million jobs according to the Congressional Budget Office

c. probably averted a 21st century "Great Depression" according to some economists

d. amounted to a major expansionary fiscal policy

e. all of these statements are accurate

17. The historical evidence of the supply side tax cuts (of the Reagan administration in

the 1980s and Bush in the 2000s) is that:

a. they were successful in increasing output, increasing tax revenues and lowering

deficits.

b. they led to lower tax revenues and higher deficits.

c. they left output, tax revenues and deficits unchanged.

d. while the Reagan tax cuts were successful in increasing tax revenues and lowering

deficits, those of the Bush administration were not.


18. Crowding out refers to ...

a. intended investment squeezing unsold inventories

b. excess consumer spending competing with foreign demand for U.S. goods

c. the demand for exports making U.S. goods for expensive for consumers

d. government borrowing reducing the availability of private capital

e. none of these

19. Table 10.2 (Different Multiplier Effects) suggests that ...

a. making the Bush income tax cuts permanent would have the biggest tax cut impact

b. a payroll tax holiday is not a very effective tax cut strategy

c. temporarily increasing food stamps is more effective than any permanent tax cut

d. cutting the corporate tax rate has a bigger impact than ANY other tax cut

e. none of these statements are accurate

20. The A1 appendix for this chapter ...

a. focuses on the use of lump-sum taxes

b. introduces the importance of the IRS for conducting fiscal policy

c. derives the balanced-budget multiplier

d. suggests that the multiplier for a change in taxes is larger than for a change in

government spending

e. none of these statements are accurate



1. fiscal policy 2. transfer payment

3. disposable

4. – (mult)(mpc)

5. balanced budget

6. outlays

7. government bonds

8. automatic stabilizers

9. outside lag

10. supply side

11. False. It is still possible to expand an economy with a balanced budget. The balanced

budget multiplier equals 1.

12. False. In the real world the multiplier is rarely this large. Econometric studies of the

U.S. economy have suggested the multiplier is 2.0 or lower.

13. True.

14. True.

15. False. The existence of deficits does not necessarily mean an expansionary fiscal policy

is being implemented. It could be that the economy is going through a downturn, so the

automatic stabilizers are kicking in, with government outlays increasing and tax

revenues declining.

16. False. It is: AE = C + II + G + NX

17. The multiplier used in this case is the same as the multiplier introduced in chapter 9:

multiplier = 1/(1−mpc)

18. The government could increase government spending, increase transfer payments, or cut

taxes.

19. It can either raise taxes, borrow, or print money. 20. The two largest sources of federal revenues are: personal income taxes and social security

taxes. The three largest categories of federal outlays are: Social security and Medicare,

social programs, and defense spending.

21. The larger the economy, the easier it is to handle a deficit. A larger economy means

higher incomes, and a greater ability for the government to collect tax revenues or sell

government bonds to finance its deficit.

22. As the economy boomed, the automatic stabilizers kicked in and tax revenues rose. The

Clinton administration also used discretionary policy, by raising taxes and thereby raising

revenues that helped turn deficits into surpluses.

23. No, tax cuts have also been a component of supply-side policy, which attempts to use tax

cuts to stimulate work, saving, investment, and thereby output. Some supply-siders

think that the growth in output can actually lead to an increase of tax revenues into the

government coffers.

24. The four types of inside lags presented in the chapter include: data lags, recognition lags,

legislative lags, and transmission lags.

25. A cyclical deficit is caused by fluctuations in the business cycle while a structural deficit

is the result of tax and spending policy decisions.

26. “Crowding out” is a reduction in the availability of private capital resulting from federal


borrowing. “Crowding in” occurs when government spending boosts expectations and

therefore induces intended investment.

Answers to Problems

1.

a. the income/spending multiplier = 1/(1 − 0.8) = 5

So solving for ∆Y = mult × ∆G,

100 million = 5 ×∆G

∆G = 20 million

b. now we need to use the tax multiplier, - mpc (mult)

So solving for ∆Y = -mpc (mult) × ∆T

100 million = -0.8 × 5 × ∆T

∆T = 100 million/-4

∆T = -25 million (a tax cut of 25 million would be needed)

c. the calculation is like part b, above, except instead of ∆T we have ∆TR. Thus,

transfers of +25 million would be needed.

d. Increasing G (government spending) would do the least damage to the deficit, raising

it by 20 million, rather than 25 million.

2.

a.

Household income mpc Income/spending

multiplier

Tax multiplier

0-$30,000 0.9 10 9

$31,000 – 50,000 0.8 5 4

$51,000 – 80,000 0.75 4 3

$80,000 and above 0.6 2.5 1.5

b. Directing the spending increase or tax cuts to the lower income households would

provide a greater stimulus, because it has a higher tax multiplier. Thus, it would do

less damage to the budget deficit to achieve a given amount of stimulus. In other

words, if the government directed tax cuts to the low-income households, it would

need a smaller tax cut to expand the economy by a given amount, and this would do

less damage to the deficit.

(Note: If one takes into account that mult may depend on an economy-wide average mpc,

this answer would still be correct, but the difference would not be as large.)


3.

a. the income/spending multiplier = 1/(1-0.75) = 4

∆Y = mult × ∆G


∆Y = 160 million

b. the tax multiplier = - 0.75 (4) = -3

∆Y = -3 × ∆T

∆Y = -3 × 40 million = -120 million

c. The net effect of the two policies is:

∆Y (a + b) = 160 million – 120 million

∆Y (a + b) = 40 million Yes, it expanded output by 40 million

d. A balanced budget rule means that one can’t respond to severe emergencies, such

as a natural disaster, war, or deal with a severe recession. Because the multiplier is

only equal to one, it provides a fairly weak stimulus.

4.

a. The biggest deficit was created during the Obama years, when the government

responded to the deep economic crisis of 2008 with large increase in spending and

tax cuts; this raised the government deficit. However, if we look at the years before

2008, the Republicans (Reagan, G. Bush Sr., G.W. Bush Jr.) appear to be the big

spenders, with their accumulation large deficits.

b. The emergence of the huge deficits under Reagan, G. Bush Sr., G.W. Bush Jr., and

Obama could be from increasing government outlays (G and TR), and/or cutting

taxes (T). The surpluses under Clinton could be from cutting government outlays (G

and TR), and/or raising taxes (T).

c. No, changes in discretionary fiscal policy are not sufficient in explaining the

emergence of deficits and surpluses, because a recessionary economy could trigger

automatic stabilizers (increases in G and TR, and falling tax revenues), whereas a

booming economy could bring forth increases in tax revenues and cuts in

government outlays. Indeed, the figure of the U.S. real GDP growth shows a deep

recession in 1981-82, which could help explain the emergence of deficits in the early

Reagan period. And the figure shows strong growth rates in the late 1990s, which

could help explain the emergence of surpluses under Clinton.

d. The economy under Clinton could have boomed for other reasons, such as the

increased investor and consumer confidence, leading to increases in investment and

consumption spending. These could have outweighed the contractionary effect of

his fiscal policies. The surpluses came about not only from the tax increases of his

discretionary policies, but also from the booming economy, which brought in


increases in tax revenues as the automatic stabilizers kicked in.

e. The tax cuts for the rich will do little to stimulate the economy because they are

directed to households with relatively lower mpcs, and thus have a smaller

multiplier effect.


1. C 2. B 3. A 4. D 5. B 6. B 7. A 8. D 9. A 10. C 11. B 12. D 13. D 14. B 15. E 16. E 17. B 18. D 19. C 20. A

Chapter 11 – Money, Banking, and Finance 1

Chapter 11

MONEY, BANKING, AND FINANCE Macroeconomics in Context (Goodwin, et al.)

Chapter Overview In this chapter, you will be introduced to a standard treatment of money and the banking

system as well as the role that banks play in our financial system. You will get an

overview of the relationship between money and the average price level, and will learn

about the role and functions of money, different types of money, and the concept of

liquidity as it applies to money. The chapter explores various types of banks and the role

they play in money creation. The functions of finance are introduced along with

nonbank financial institutions. The final section of the chapter presents a brief survey of

financialization and financial asset bubbles.

Objectives After reading and reviewing this chapter, you should be able to:

1. Describe the consequences of inflation and deflation.

2. Describe the functions and types of money.

3. Describe the measures of the money supply and explain the liquidity continuum.

4. Explain the basic workings of private banks including the use of balance sheets.

5. Explain how banks create money.

6. Describe the categories and functions of nonbank financial institutions.

7. Explain the concept of “financialization” and provide examples.

8. Explain the concept of “speculative bubble” and illustrate it with concrete examples.

Key Terms

monetary policy

barter

deflation

liquidity

credit money

commodity money

intrinsic value

gold standard

fiat money

exchange value

M1

M2

financial intermediary

economic liability

bank reserves

fractional reserve system

required reserves

excess reserves

portfolio investment

leverage

non-bank financial institution

collective investment vehicle

hedge fund

pension fund

insurance company

securities broker

mortgage broker

shadow banking


Active Review

Fill in the Blank

1. The fact that money can be immediately used in exchange, whereas valuable

jewelry cannot, illustrates the fact that money is very __________________.

2. The measure of the money supply that includes currency in circulation,

traveler’s checks, and checking accounts is called __________________.

3. When the aggregate price level falls economists use the term ____________

to describe the situation.

4. When something contains intrinsic value and also serves as a medium of

exchange it is known as ____________________.

5. The __________ definition of the money supply is broad enough to include

savings deposits as well as checkable deposits and currency.

6. A medium of exchange that is valuable because a government says that it has

value is known as _______________.

7. Institutions that accept funds and provide loans are known as

_________________________.

8. Vault cash and deposits at the Federal Reserve both count towards

_____________, a term that describes funds not lent out or invested by a

private bank.

9. When banks are only required to hold a fraction of their deposits on reserve

they are part of _________________________.

10. The portion of bank reserves that a bank must keep on reserve are known as

_______________________.

11. The portion of bank reserves that banks are permitted to lend or invest are

known as _______________________.

12. The use of debt to increase the potential rate of return on one’s own

investment is called __________________.

13. One alternative to saving money in a bank is to use a

______________________ , which is a category of pooled funds.


14. A _______________ is a type of pooled fund that often engages in highly

speculative investments and is generally restricted to wealthy clients.

15. An agent responsible for finding a buyer for sellers of different securities is

known as a ____________________.

True or False

16. When a government finances its expenditures by printing money rather

than collecting taxes, this can lead to “too much money chasing too few

goods” and hyperinflation.

17. Coins and paper money have in some periods been commodity money and in

other periods fiat money.

18. Nelson takes a $100 bill he had in his wallet and deposits it into his

checking account. Thus, M1 increases by $100.

Short Answer

19. Why is inflation harmful to an economy?

20. Why is deflation harmful to an economy?

21. What are the three roles of money? And what are two types of money?


22. Identify the components of M1 and M2.

23. Explain the difference between required reserves and excess reserves.

24. Explain the difference between a commercial bank and an investment bank.

25. What was the Glass-Steagall Act? Why was it originally passed? Why have some

economists argued that elements of the Act should be restored?


Problems

1. Jane Doe has the following assets.

$100 in her wallet

$800 in her checking account

$1,000 in her savings account

A $20 traveler’s check from her last business trip to China.

A $300 outstanding credit card bill.

$3,000 in a small certificate of deposit

A car worth $5,000.

A house, worth $200,000.

a. Identify which are in M1, which are in M2, or in neither M1 nor M2.

b. Suppose she takes the $100 in her wallet and deposits it in her checking account.

What is the change in M1 and M2?

c. Suppose she takes $400 from her checking account and deposits it in her savings

account. What is the change in M1 and M2?

2. Assume a required reserve ratio of 0.10 to complete the following.

Assets Liabilities & Net Worth

Reserves $ 150 million Deposits $ 500 million

Loans $ 250 million Bank Capital $ 25 million

Bonds $ 125 million

TOTAL: 525 Million TOTAL: $ 525 Million

a) Calculate the initial required reserves for this bank.

b) Calculate the initial excess reserves for this bank.

c) Convert all of the excess reserves into loans. Construct the new balance sheet.


Self Test

1. Which of the following is not a reason why an unexpected episode of inflation is

harmful to an economy?

a. It wipes out the value of people’s savings.

b. It hurts people on fixed incomes, such as retired people who receive non-indexed

pensions.

c. It redistributes wealth from debtors to creditors.

d. It creates menu costs.

e. It creates uncertainty, which makes financial planning for the future more

difficult.

2. Hyperinflation …

a. is often defined as any annual inflation rate higher than 10 percent.

b. describes the German economy after World War II.

c. can be become so severe that people resort to barter.

d. means that people tend to save money much more aggressively.

e. none of these statements is accurate.

3. According to the textbook, why is deflation harmful to an economy?

a. It redistributes wealth from debtors to creditors.

b. It creates menu costs.

c. It creates uncertainty, which makes financial planning for the future more

difficult.

d. It can lead to cutbacks in borrowing and spending, which can slow down the

economy.


4. Which of the following is NOT a function of money?

a. A hedge against inflation.

b. A unit of account.

c. A store of value.

d. A medium of exchange.

e. All of these are functions of money.

5. Which of the following is NOT a type of money described in the textbook?

a. Fishhooks as money.

b. Fiat money.

c. Commodity money.

d. Silver coins as money.

e. All of these are types described in the text.


6. “Fiat money” refers to …

a. Older U.S. coins that contain a high (90%) silver content.

b. A creative alternative to modern money (such as cigarettes in a prisoner of war

camp.)

c. Money that is valuable because a government says it has value.

d. Paper money backed by gold or other precious metals.

e. None of these is fiat money.

7. Which of the following is the most liquid?

a. A $20 bill in your pocket

b. A gold necklace

c. Three shares of Microsoft stock

d. A certificate of deposit (CD) in your bank.

e. A new Toyota Prius automobile

8. Which of these sequences best captures the liquidity continuum?

a. Checking accounts, precious metal, real estate, share of stock

b. Checking accounts, precious metal, share of stock, real estate

c. Checking accounts, share of stock, precious metal, real estate

d. Checking accounts, share of stock, real estate, precious metal

e. Precious metal, checking accounts, share of stock, real estate

9. Which of the following is not one of the characteristics necessary for commodity

money to be used as money?

a. It must be durable.

b. It must be portable.

c. It must be generally acceptable.

d. It must be differentiated.

e. It must be scarce.

10. Which of the following is not included as “money” in M1?

a. Currency in circulation

b. Checkable deposits

c. Traveler’s checks

d. The use of a credit card

e. The use of debit cards that take funds from a checking account


11. Suppose Tabatha takes $500 from her savings account and deposits it in her

checking account. What is the change in M1 and M2?

a. M1 increases and M2 decreases

b. M1 increases and M2 remains unchanged

c. M1 and M2 both increase

d. M2 increases and M1 remains unchanged

e. M1 and M2 both remain unchanged

12. Which of the following is NOT a component of the M2 definition of the money supply?

a. Certificates of deposit

b. Checking account deposits

c. Retail money market funds

d. Travelers checks

e. All of these are components of the M2 definition of the money supply.

13. Which of these is (was) NOT a financial intermediary?

a. The New York Stock Exchange

b. Bank of America

c. MetLife Insurance Company

d. Washington Mutual Savings and Loan

e. All of these are (were) financial intermediaries.

14. Which of these would be an INCORRECT use a balance sheet for a private bank?

a. A “government bonds” entry listed as an asset.

b. A “deposits” entry listed as a liability.

c. A “loans” entry listed as an asset.

d. Both (b) and (c) are incorrect.

e. All three of (a), (b), AND (c) are correct entries.

15. Which of these is NOT an example of a bank type described in the textbook?

a. Goldman Sachs investment bank

b. Washington Mutual Savings and Loan

c. Service Federal Credit Union

d. The Federal Reserve

e. All of these are examples of bank types described in the textbook.


16. The Glass-Steagall Act …

a. was passed in 2009 to prevent future financial crises.

b. was strengthened in 1999 to increase financial regulation.

c. was passed in the late 1980s in response to the Savings & Loan crisis.

d. was passed in the 1930s to increase financial regulation.

e. None of these is correct.

17. Which of these is NOT an example of leverage?

a. An investment bank increases its liabilities to speculate on derivatives.

b. A local entrepreneur borrows heavily to finance the cost of starting a new business.

c. General Motors issues new stock to raise funds for a new factory.

d. Microsoft issues commercial bonds to finance production of a new product.

e. All of these are examples of leverage.

18. A hedge fund is an example of …

a. a financial intermediary

b. a nonbank financial institution

c. an investment bank

d. a pension fund

e. None of these.

19. Nonbank institutions …

a. have been growing in importance in our financial system.

b. often provide much more attractive alternatives to traditional savings accounts.

c. are typically subject to less government regulation than traditional banks.

d. include pension funds and insurance companies.

e. All of these statements are accurate.

20. Speculative bubbles …

a. generally form for psychological and economic reasons.

b. are an important source of economic growth.

c. generally occur due to a general lack of liquidity.

d. are generally associated with tight credit conditions.

e. None of these statements is true.



1. liquid

2. M1

3. deflation

4. commodity money

5. M2

6. fiat money

7. financial intermediaries

8. bank reserves

9. fractional reserve system

10. required reserves

11. excess reserves

12. leverage

13. collective investment vehicle

14. hedge fund

15. securities broker

16. True.

17. True.

18. False, M1 remains unchanged. There has just been a change in the composition of M1,

but the size of M1 remains the same.

19. Inflation is harmful because: it wipes out the value of people’s savings; it hurts people

on fixed incomes; it redistributes wealth from creditors to debtors; it creates menu

costs; and it creates uncertainty, making financial planning for the future more

difficult.

20. Deflation is a problem because: it redistributes wealth from debtors to creditors, it

creates menu costs; it creates uncertainty, making financial planning for the future more

difficult; and it can lead to cutbacks in borrowing and spending, which can slow down

the economy.

21. The three roles of money are: medium of exchange, store of value, and unit of

account. Two types of money are commodity money and fiat money. Commodity

money is a good that is used as money that is also valuable in itself. Fiat money

is a medium of exchange used as money because the government declares it as

such and people accept it.

22. M1 consists of currency in circulation, traveler’s checks, and checkable deposits.

M2 consists of all of M1, plus savings accounts, and other funds such as small

certificates of deposit and retail money market funds.

23. Banks generate much of their profit from the use of other peoples’ money. Checking

account deposits entrusted to banks are also known as “demand deposits” because

the depositors have access to their money whenever they want. Consequently banks

are obligated to hold a minimal portion of these deposits in liquid reserves. This

portion is a percentage (set by the Federal Reserve in the U.S.) of total deposits and

is known as required reserves. All of the reserves a bank has beyond this category

of required reserves are referred to as excess reserves.

24. Commercial banks provide retail services to individuals and businesses. These are

the institutions that we typically associate with checking accounts and lending.

Investment banks are institutions that focus on underwriting and issuing securities.

They do not provide traditional banking functions.


25. The Glass-Steagall Act was a 1933 legislative attempt to provide greater stability

for the banking system through increased government regulation. It contained a

number of provisions including the separation of commercial banking from

investment banking. Some economists have argued that a “firewall” such as the one

provided by Glass-Steagall should be restored between institutions that are

federally insured (by the FDIC) and investment banks because of differences in

risk-taking across the two types of banks.

Answers to Problems

1.

a. The following are in M1, M2, or neither:

$100 in her wallet = M1

$800 in her checking account = M1

$1,000 in her savings account = M2

A $20 traveler’s check from her last business trip to China = M1

A $300 outstanding credit card bill = Neither

$3,000 in a small certificate of deposit = M2

A car worth $5,000 = Neither

A house, worth $200,000 = Neither

b. M1 and M2 remain unchanged, since both cash and checking account deposits are

counted in both M1 and M2.

c. M1 decreases by $400, and M2 remains unchanged.

2.

a. Required Reserves = reserve ratio * deposits

= (0.10) * 500 million

= $ 50 million

b. Excess Reserves = total reserves – required reserves

= 150 million – 50 million

= $ 100 million

c.

Assets Liabilities & Net Worth

Reserves $ 50 million Deposits $ 500 million

Loans $ 350 million Bank Capital $ 25 million

Bonds $ 125 million

TOTAL: 525 Million TOTAL: $ 525 Million



1. C

2. C

3. E

4. A

5. E

6. C

7. A

8. C

9. D

10. D

11. B

12. E

13. A

14. B

15. E

16. D

17. C

18. B

19. E

20. A

(note on #1: Inflation redistributes wealth from creditors to debtors)

Chapter 12 – The Federal Reserve and Monetary Policy 1

Chapter 12

THE FEDERAL RESERVE AND MONETARY POLICY Macroeconomics in Context (Goodwin, et al.)

Chapter Overview In this chapter, you will be introduced to a standard treatment of central banking and

monetary policy. You will learn about the role of the Federal Reserve and how the

decisions made at the Fed impact the macroeconomy. You will be introduced to the market

for federal funds, and learn how the Federal Reserve attempts to expand or cool off the

economy using monetary policy. You will also be introduced to the quantity equation, the

quantity theory of money, and monetarism. In the appendixes you will be introduced to

bonds and different ways of thinking about interest rates.

Chapter Objectives After reading and reviewing this chapter, the student should be able to:

1. Understand the basic workings of central banks.

2. Describe the tools the Federal Reserve can use to carry out monetary policy.

3. Understand how the Fed uses open market operations to influence the federal funds rate.

4. Explain how monetary policy is expected to affect investment and aggregate expenditure.

5. Explain the U.S. monetary policy experience of the 2000-2017 period in the context of

Federal Reserve priorities and monetary policy actions.

6. Become familiar with the notions of “liquidity trap” and “credit rationing.”

7. Understand the quantity equation, the quantity theory of money, and monetarism.

7. Describe possible sources of inflation.

8. Understand the controversy over rules versus activism in monetary policy.

If the Appendix is included:

9. Understand the use of bonds and the relation of bond prices to interest rates

10. Understand the difference between real and nominal interest rates, and their

impact on the economy.

11. Describe the transactions demand model of money.

Key Terms

open market operations

Federal Open Market Committee (FOMC)

monetary base (or high-powered money)

money multiplier

discount rate

federal funds rate

primate rate

accelerator principle

expansionary monetary policy

accommodative monetary policy

contractionary monetary policy

quantitative easing (QE)

liquidity trap

credit rationing

quantity equation

velocity of money

quantity theory of money

monetary neutrality

money supply rule

monetarism


monetizing the deficit

modern monetary theory

Appendix:

bond

real interest rate

expected real interest rate

transactions demand

precautionary demand

speculative demand

Active Review

Fill in the Blank

1. When the Federal Open Market Committee (FOMC) directs the Federal Reserve Bank

in New York to buy or sell government bonds on the open market, it is conducting

.

2. Suppose the Fed buys bonds on the open market. By doing so, it is increasing the

_______________ (also known as ____________), which is the currency in circulation

plus bank reserves.

3. The ratio of the money supply to the monetary base is called the ,

and in the U.S. is empirically estimated to have a value close to two. 4. The interest rate that the Fed charges banks on loans it makes to banks so they can

to meet their reserve requirements is called the .

5. The interest rate that banks pay one another when they borrow on an overnight

basis is called the ______________________.

6. The _____________ is the interest rate that banks charge their most creditworthy

commercial borrowers.

7. The idea that high GDP growth has a bigger impact on intended investment spending

than do interest rates, and thus leads to high investment growth is called the

.

8. The central bank process of buying diverse financial assets with the goal of creating

more monetary reserves is known as ____________________________.

9. When interest rates are so low that the Central Bank finds it impossible to lower

them any further, the economy is in a ________________________.

10. In cases where inflation is a significant problem and the banking system is unstable,

it is useful to use the _________, which analyzes the relationships between the money

supply, the velocity of money, the price level, and real output.

11. The theory that assumes that the velocity of money is constant in the equation


M × V = P × Y is the .

12. ________________________ is the idea that changes in the money supply may

affect only prices, while leaving output unchanged.

13. When a central bank buys government debt as it is issued and thereby injects new

money into the economy it is said to be ________________, which can trigger

hyperinflation.

14. (Appendix) A financial instrument that commits its seller to pay a fixed amount

every year, in addition to repaying the amount of the principal on a particular date in the

future, in return for the loan of funds, is called a .

15. (Appendix) The nominal interest rate minus inflation is the .

16. (Appendix) The three reasons that people choose to hold some of their assets as money

include _____________________, ____________________, and

______________________.

True or False

17. The most common monetary policy tool used by the Fed is changing the discount

rate.

18. A contractionary or “tight” money policy entails a decrease (or fall in the growth rate

of) the money supply, M1, leading to a lower interest rate.

19. When the Fed conducts open market operations, it is either trying to keep the federal

funds rate at its existing level, or trying to push the federal funds rate up or down.

20. Quantitative easing refers to the purchase of a diverse collection of financial assets

to increase the money supply.

21. The quantity theory of money is an important component of Keynesian thinking.

Short Answer

22. Describe the structure of the Federal Reserve. How many governors are on the

board, and how long is each governor’s term? Who appoints them? How many regional

banks does the Fed have? 23. Is the role (or function) of the Fed only to conduct monetary policy (e.g. raise or

lower interest rates)?


24. Identify the three tools of monetary policy, and what the Fed would do to increase

(or decrease) the (growth of the) money supply.

25. Explain the sequence of links connecting an expansionary monetary policy with

interest rates, intended investment, aggregate expenditure, and output.

26. Suppose the economy is characterized by inflation problems and an unstable banking

system. Use the quantity equation, M × V=P × Y, to answer the following questions:

a. What assumptions does the classical theory make about the variables in the

quantity equation?

b. What assumptions does monetarist theory make about the variables?

c. What assumptions do Keynesian-oriented theories make?

d. How does monetarist theory use the quantity equation to explain the deflation and

fall in output in the U.S. during the Great Depression?

e. How might a Keynesian-oriented theorist use the quantity equation to explain the

cause of hyperinflation?

f. Provide two cases where inflation is caused by some factor other than an increase

in the money supply.

Problems 1. Suppose the Fed buys $5 million worth of government bonds from TrustMe bank.

a. Show the changes in the Fed’s Balance sheet, and the changes in TrustMe

bank’s balance sheet.

b. How much in new loans can TrustMe Bank make, given this change in its

balance sheet? (Assume the borrowers deposit the amount they borrow in other

banks.)

c. Assume that when the new loans are deposited in other banks in the banking

system, all these banks loan out all of their excess reserves. Assume further that the

money multiplier equals 2. By how much has the money supply increased from the

Fed’s bond purchase?


2. Suppose the Fed conducts an expansionary monetary policy. (Assume an economy

with low inflation and a stable banking system). Illustrate graphically the effects of this

expansionary monetary policy on:

a) The market for federal funds

b) Intended investment spending

c) Aggregate Expenditure and output

d) Suppose now that firms become pessimistic as they expect a fall in GDP and a fall in

sales, such that the expansionary policy leaves no effect on aggregate expenditure and

output. Illustrate graphically by re-doing the graphs in a-c above.


Self Test 1. Which of the following is not one of the functions of the Federal Reserve?

a. Performing banking functions for private banks

b. Issuing Treasury bills and bonds

c. Regulating banks

d. Promoting confidence and stability in the financial sector

e. Conducting monetary policy.

2. An open market purchase by the Fed

a. increases bank reserves, loans, and deposits, and thus increases the money supply.

b. decreases bank reserves, loans, and deposits, and thus decreases the money

supply.

c. increases bank reserves, loans, and deposits, and thus decreases the money

supply.

d. decreases bank reserves, loans, and deposits, and thus increases the money

supply.


3. Suppose the Fed buys $15 million worth of government bonds from Richland bank.

Which of the following is Richland Bank most likely to do?

a. Reduce its outstanding loans by $15 million.

b. Borrow more reserves at the “discount window”

c. Borrow more reserves from other banks.

d. Make new loans totaling about $15 million.


4. Suppose the Fed makes an open market purchase of $3 million. Assume that

the money multiplier equals 2. What is the change in the money supply?

a. The money supply has increased by $1.5 million.

b. The money supply has increased by $6 million.

c. The money supply had decreased by $1.5 million.

d. The money supply has decreased by $6 million.


5. Suppose the Fed makes an open market sale of $8 million in bonds. Assume the

money multiplier is equal to 2. What is the change in the money supply?

a. The money supply has increased by $4 million.

b. The money supply has decreased by $4 million.

c. The money supply has increased by $16 million.

d. The money supply has decreased by $16 million.



6. Which of the following is not one of the Fed’s monetary policy tools?

a. Buying bonds on the open market

b. Selling bonds on the open market

c. Raising or lowering taxes

d. Raising or lowering the reserve requirement ratio

e. Raising or lowering the discount rate

7. Suppose the Fed wanted to engage in an expansionary monetary policy. Which of

the following should it do?

a. Sell bonds on the open market.

b. Increase the reserve requirement ratio.

c. Increase the discount rate.

d. Buy bonds on the open market.

e. Lower taxes.

8. The rate determined in the private market for overnight loans of reserves among

banks is called the

a. federal funds rate

b. discount rate

c. prime rate

d. interest rate


9. Which of the following best describes the sequence of events in the conduct of

contractionary monetary policy using open market operations (in an economy with

low inflation and a stable banking system)?

a. The Fed raises the interest rate, which leads to a decrease in intended investment

spending and a decrease in the supply of federal funds, which decreases aggregate

expenditure and output.

b. The Fed decreases intended investment spending, which leads to a decrease in

aggregate expenditure and output, and a decrease in the supply of federal funds

and the interest rate.

c. The Fed sells bonds, which decreases the supply of federal funds, which raises the

interest rate, which leads to a decrease in intended investment spending, aggregate

expenditure and output.

d. The Fed buys bonds, which increases the supply of federal funds, which lowers

the interest rate, and leads to a decrease in intended investment spending and

aggregate expenditure and output.

e. The Fed lowers the interest rate, which leads to an increase in intended investment

spending and an increase in the supply of federal funds, which decreases

aggregate expenditure and output.


10. What did the Federal Reserve do to expand the economy during the 2000-04 period?

a. It pushed down the federal funds rate.

b. It raised the reserve requirement ratio.

c. It raised the discount rate.

d. It sold bonds on the open market.


11. A liquidity trap refers to a situation when

a. The economy is trapped by a flood of money on the market.

b. A rise in interest rates causes people to want to hold less money.

c. Households’ wealth becomes trapped in assets that cannot be easily exchanged

into money.

d. The general public has a strong preference for holding the most liquid asset,

money.


12. During a liquidity trap,

a. as the Fed increases the money supply, the interest rate falls significantly.

b. increases in the money supply have no effect on the interest rate, because the

money demand curve has become perfectly horizontal.

c. as the Fed increases the money supply, the interest rate rises substantially.

d. once the Fed increases the money supply, it can no longer control it, which leads

to hyperinflation.

e. monetary policy is highly effective in expanding the economy

13. When credit rationing occurs,

a. banks keep their interest rates below what the market would bear, and deny loans

to some potential borrowers.

b. Banks lend to only those customers deemed to be creditworthy and less risky.

c. Smaller and less well-known firms may be more disadvantaged than bigger firms

with well-established reputations.

d. The Fed’s intended monetary policy actions may be limited or ineffective.


14. Which theory (or theories) assumes that the velocity of money is not constant, in the

quantity equation M × V = P × Y?

a. Classical theory

b. Monetarist theory

c. Keynesian-influenced theories

d. The theory expounded by Milton Friedman and Anna Jacobson Schwartz e. None of the above


15. Which of the following characterizes classical monetary theory?

a. Output is assumed to be always constant at its full-employment level.

b. Changes in the money supply have no effect on the level of real output, and thus

money is assumed to be neutral.

c. An increase in the money supply can only lead to inflation.

d. The Fed should adopt a money supply rule, allowing the money supply to grow

only at the same rate as real GDP.


For the next two questions, consider the following choices:

I. the Classical theory

II. Monetarism

III. Keynesian-oriented theories

16. Which of the above theories would be in agreement with the following statement?

“The Fed should not use interventionist monetary policy, but should adopt a money

supply rule such that the money supply is only allowed to grow at a steady rate --

the same rate as real GDP.”

a. I

b. II

c. III

d. I and II

e. I, II, and III

17. Which of the above theories would be in agreement with the following statement?

“Inflation is always and everywhere a monetary phenomenon.”

a. I

b. II

c. III

d. I and II

e. I, II, and III 18. Which of the following is not one of the potential problems of monetary policy?

a. long “outside lags”

b. long “inside lags”

c. disagreement over inflation and unemployment targets

d. liquidity traps

e. reluctant lenders and reluctant borrowers


From Appendix:

19. What happens to bond prices and their interest rate when the Fed makes a sizeable

open market purchase?

a. The price of bonds rises and their interest rate falls.

b. The price of bonds falls and their interest rate rises.

c. The price of bonds rises and their interest rate rises.

d. The price of bonds falls and their interest rate falls.

e. The price of bonds and their interest rate remain unchanged.

20. What is the difference between the nominal and real interest rate?

a. The nominal interest rate is the real interest rate minus the rate of inflation.

b. The real interest rate is the nominal rate plus the rate of inflation.

c. The real interest rate is the nominal rate minus the rate of inflation.

d. The nominal interest rate is the real interest rate plus the rate of inflation.

e. There is no difference between real and nominal interest rates.


Answers to Active Review Questions 1. open market operations

2. monetary base, high-powered money

3. money multiplier

4. discount rate

5. federal funds rate

6. prime rate

7. accelerator principle

8. quantitative easing

9. liquidity trap

10. quantity equation

11. quantity theory of money

12. monetary neutrality

13. monetizing the deficit

14. (Appendix) bond

15. (Appendix) real interest rate

16. (Appendix) transactions demand, precautionary demand, and speculative demand

17. False. It is open market operations.

18. False. With “tight” policy, the interest rate rises.

19. True.

20. True.

21. False. It is an important component of the classical theory and monetarism.

22. The Fed’s board of governors has seven members who serve fourteen-year terms.

They are nominated by the president and approved by the Senate, and one member of the

board is named as chair. There are also 12 regional Federal Reserve banks.

23. No, the Fed is supposed to do more than that. Its roles include: performing banking

functions for private banks; determining reserve requirements; stabilizing exchange rates;

regulating banks; promoting confidence and stability in the banking sector; as well as

conducting monetary policy.

24. The three tools of monetary policy are: open market operations (buying and selling of

bonds), discount rate, and reserve requirement. To increase the (growth of the) money

supply, the Fed could either buy bonds, lower the reserve requirement ratio, or lower the

discount rate. To decrease the (growth of the) money supply, the Fed could either sell

bonds, raise the reserve requirement ratio, or

raise the discount rate.

25. An expansionary monetary policy will lower interest rates, which tends to encourage

intended investment, leading to an increase in aggregate expenditure and output (GDP).

26. a. Classical theory assumes that velocity is constant, and that the economy is always constant at the full employment level of income.

b. Monetarism also assumes that velocity is constant, but relaxes the assumption that

the economy is always constant at full employment, and believes that output can

fall with bad monetary policy.

c. Keynesian-oriented theories assume none of the variables (in particular neither

velocity or output) are constant.

d. The monetarists thought that the bad monetary policy of decreasing the money

supply caused both a drop in the price level (deflation) and a fall in output during

the Great Depression.

e. A dramatic rise in the money supply (especially if the central bank is monetizing


deficits) and/or the velocity of money could trigger hyperinflation.

f. Inflation could be caused by an increase in the velocity of money, or by rise in

prices of imports.

Answers to Problems

1. Suppose the Fed buys $5 million worth of government bonds from TrustMe bank. a.

The changes in the Fed’s Balance sheet are:

Assets Liabilities

Government bonds +$ 5 million Bank reserves +$ 5 million

(b) The changes in TrustMe bank’s balance sheet are:

Assets Liabilities

Government bonds −$ 5 million

Reserves +$ 5 million b. $5 million

c. $5 million × 2 = $10 million

2. Effects of an expansionary monetary policy:

a.


b.

c.

d. If firms become pessimistic as they expect a fall in GDP and a fall in sales:

Graph a would remain the same, as above.

Graph b would now look as follows, as the drop in confidence leads to a fall in II0 to II1,

so intended investment spending remains at its original level:

Agg

rega

te E

xpen

dit

ure

an

d O

utp

ut

45◦

E0

E1

Y1 Y0Income

AE1 (with new, lower interest rate, r1)

AE0 (with old interest rate, r0)


Graph c would now look like as follows, where AE remains unchanged, but at the lower

interest rate:


1. B

2. A

3. D

4. B

5. D

6. C

7. D

8. A

9. C

10. A

11. D

12. B

13. E

14. C

15. E

16. D

17. D

18. B

19. A

20. C

Chapter 13 – Aggregate Supply, Aggregate Demand, And Inflation 1

Chapter 13

AGGREGATE SUPPLY, AGGREGATE DEMAND,

AND INFLATION: PUTTING IT ALL TOGETHER Macroeconomics in Context (Goodwin, et al.)

Chapter Overview

This chapter introduces you to the "Aggregate Supply /Aggregate Demand" (or

"AS/AD") model. This model builds on the model for Aggregate Expenditure (AE)

presented in Chapter 9, using the broader term “aggregate demand” to include explicit

attention to the potential problem of inflation. The chapter also adds in the role of

aggregate supply by presenting an Aggregate Supply curve. The AS/AD model is then

deployed to analyze various current and past events (such as changes in fiscal and

monetary policy, supply shocks, and other changes) and examine their effects on the

rate of inflation and output. The chapter reviews real-life examples of U.S.

macroeconomic performance seen through the lens of the AS/AD model. It also

compares the classical school, with their view of a stable full employment equilibrium,

to the Keynesians with their view of a dynamically evolving economy.

Chapter Objectives


1. Explain the derivation of the Aggregate Demand curve relating inflation and

output levels, and how it shifts. 2. Explain the derivation of the Aggregate Supply curve relating inflation and

output levels, and how it shifts.

3. Use the AS/AD model to describe the consequences of changes in fiscal policy,

monetary policy, supply shocks, and investor and consumer confidence,

depending on whether an economic is in a recession or at full employment.

4. Apply the AS/AD model to understanding major U.S. macroeconomic

developments of the last several decades.

5. Discuss how classical and Keynesian economic theories differ in how they

understand the macroeconomy. Key Terms aggregate demand (AD) curve real wealth effect real money supply aggregate supply (AS) curve maximum capacity output wage-price spiral wage and price controls disinflation supply shock stagflation

Appendix: real business cycle theory rational expectations theory neoclassical synthesis New Keynesian macroeconomics post-Keynesian macroeconomics path dependence

Chapter 13 – Aggregate Supply, Aggregate Demand, and Inflation: Putting It All Together 2

Active Review

Fill in the Blank

1. The curve that shows how inflation is related to total demand, and indicates an

inverse relationship between inflation and output, is called the _____________ curve.

2. The tendency for consumers to increase or decrease their consumption based on their

perceived level of wealth is described as the effect.

3. The nominal money supply divided by the general price level is known as the

________________.

4. The curve that shows the combination of output and inflation that can occur in an

economy, given the country’s capacity constraints, is called the curve.

5. Assume that a nation is fully using every last one of its available resources in

production. Then that nation would be operating at output.

6. When demand for labor and other resources is high, and that bids up wages, which in

turn bids up prices as producers try to cover their higher cost of production, which then

puts further upward pressure on wages as workers demand compensation for higher

prices, etc., the result is what is called a .

7. During WWII, the government established to keep inflation from

spiraling out of control.

8. Something that changes the ability of an economy to produce goods and services (such

as a natural disaster, a war, change in productivity, or change in the price of a key input

like oil) is called a .

9. The presence of both economic stagnation (with rising unemployment) and rising

inflation is known as .

10. Suppose people experience a higher level of inflation for a period of time, and

begin to build in that higher rate of inflation into their contacts. This would be

characterized as an increase in ________________ 11. (In appendix) The theory that changes in employment levels are caused by change in

technological capacities or people’s preferences concerning work is a theory associated

with .

12. (In appendix). The theory that said that people will use all available information,

including rational anticipation of the Fed’s monetary policy movements, and will

immediately incorporate changes in inflationary expectations into their contracts, is

associated with the school.


13. (In appendix) A combination of classical and Keynesian views, with Keynesian

theory applied to the short and medium run, but the classical view prevailing in the

long run, is known as the .

14. (In appendix) The school of thought which bases their analysis on rational,

optimizing individuals and micro-level market behavior, but believes that the adjustment

to full employment equilibrium could take a relatively long time, is called

.

15. (In appendix) The school of thought that believes that economies are unstable, that

history matters, and that the future is often unpredictable, is called .

True or False

16. According to the AS curve, at the “full employment” range of output the

unemployment rate is 0%.

17. According to classical theory, any shifts in the AD curve will only lead to changes

in inflation, and leave output unchanged.

18. There is a clear relationship between unemployment and inflation: inflation is low

during periods of high unemployment and as unemployment declines inflation rate

increases.

19. Stagflation is the combination of stagnation and deflation.

20. An oil price shock (assuming all else remains the same) can lead to stagflation.

Short Answer

21. Why is the AD curve downward sloping?

22. What variables would cause a shift in the AD curve? 23. What are the five regions of the aggregate supply curve diagram?

24. Why is the AS curve gently rising in the full employment range? 25. Why is the AS curve flat, rather than upward sloping, in the recession range?

26. Why is there no immediate response in the AS curve to an increase in inflation?

27. What factors would cause a shift in the AS curve (and in some cases, the maximum

output)? 28. What is the classical school’s rationale for the slope of the AS curve?


29. One of the simplifying assumptions in the macroeconomic AD/AS model is that only

the level of spending is important, not its composition. What does the “composition of

spending” entail? 30. (In appendix) Is the difference between the classical school and the Keynesians only a

matter of time (i.e. the time of the adjustment to the long run full employment

equilibrium), or is there a more fundamental difference in world view between the two

approaches?

Problems

1. Fill in the missing labels on the graph below:

A:

B:

C:

D:

E:

F:

G:

H:

H


2. For each of the following, illustrate the shift of one of the curves in the AS/AD

model:

a. Business confidence rises as firms expect an increase in GDP, sales, and profits.

b. A rise in inflation increases people’s expectations of inflation in the medium run.

c. The distribution of high speed internet to rural areas boosts productivity.

3. Illustrate the following periods of history with the AS/AD model:

a. Government spending for the Vietnam War during the late 1960s pushed up the rate

of inflation from about 1% to 5%. b. In 1973-74, OPEC engaged in an oil embargo, causing an increase in oil prices.

Inflation rose to above 9% in 1975, and the unemployment rate rose above 8%.

(Illustrate the immediate effect.) c. After another oil price shock in 1979, the Fed conducted a contractionary monetary

policy (choosing a lower target inflation rate). Inflationary expectations fell. The

unemployment rate rose to almost 10%, but inflation fell from 9% to 4%. d. The 1990s brought an era of innovation, increasing global competition, and

weakened unions from years of anti-union government policies. By 1998, the

unemployment rate was 4.4% and inflation was 1.6%.

Self Test

1. Which of these factors explain why the AD curve is downward-sloping?

a. With higher inflation, consumers real income and wealth is less and they

consume less, resulting in lower output.

b. With higher inflation, the real money supply will be lower, resulting in lower

output.

c. Because with higher inflation, exports will be more expensive, resulting in less

net exports and lower output.

d. As inflation increases, the Fed will raise interest rates and slow down the

economy, resulting in lower output.



2. Which of the following would not cause a shift in the aggregate demand (AD) curve?

a. The government cuts taxes.

b. Expectations of a growing economy lift business confidence and investment.

c. The Fed chooses a more expansionary monetary policy.

d. Technological progress improves productivity.

e. Consumers increase autonomous spending.

3. Which of the following is not one of the five regions of the aggregate supply curve

diagram?

a. Maximum capacity output

b. Wage-price spiral

c. Full employment range of output

d. Unemployment

e. Net exports

4. What is the shape of the AS curve in the full employment range?

a. Flat and horizontal

b. Gently rising upwards c.

Steeply rising upwards d.

Completely vertical

e. Downward sloping

5. Which of the following would not cause a shift in the AS curve?

a. A natural occurrence, such as a bumper crop in agriculture.

b. An increase in labor productivity.

c. An increase in a key input of production, such as oil prices.

d. A change in investment spending.

e. A change in inflation that changes people’s expectations of

inflation in the medium run.

6. Which of the following would not cause a shift in both the AS curve and maximum

capacity output?

a. A natural occurrence, such as a bumper crop in agriculture.

b. An increase in labor productivity.

c. An increase in the price of a key input of production, such as oil.

d. A change in inflation that changes people’s expectations of inflation in the

medium run.



7. Which of the following would cause the AD curve to shift to the right?

a. The government raises income taxes.

b. Firms become pessimistic about the future growth of GDP, sales, and profits.

c. The Fed shifts to a more expansionary monetary policy.

d. Workers build expectations of higher inflation into their contracts.


8. What could cause both the AS curve and maximum capacity to shift to the right?

a. A decrease in labor productivity.

b. A decrease in inflationary expectations.

c. A cut in income taxes.

d. The distribution of high-speed internet access to rural areas in the U.S.


9. Suppose a war destroys much of a nation’s infrastructure. Assume everything else

remains unchanged. How would the impact be illustrated with the AS/AD model?

a. AD shifts right/up.

b. AD shifts left/down.

c. AS and maximum capacity shift right.

d. AS and maximum capacity shift left.

e. AS, AD and maximum capacity remain unchanged.

10. Suppose the U.S. Congress passes a stimulus package with tax rebates for all

qualifying U.S. households. Assume everything else remains unchanged. How would

the impact be illustrated with the AS/AD model?

a. AD shifts right.

b. AD shifts left.

c. AS and maximum capacity shift right/down.

d. AS and maximum capacity shift left/up.

e. AS, AD and maximum capacity both shift left.

11. Suppose we observe an increase in inflation and a decrease in output. Which of the

following could be the cause?

a. The Fed has chosen a lower inflation target.

b. Good weather has produced a bumper harvest.

c. An increase in consumer confidence has boosted consumption spending

d. The price of a key input, oil, has increased.



12. In the figure below, which of the following events could explain the shift of the AD

curve to the right?

a. An increase in government spending.

b. A tax increase.

c. An increase in consumer and investor confidence.

d. (a) and (c) only.

e. (b) and (c) only.

13. In the figure below, which of the following events could explain the upward shift of

the AS curve, and the leftward shift of the AD curve?

a. A tax cut.

b. An increase in government spending.

c. An increase in inflationary expectations, followed by a contractionary fiscal

policy.

d. A decrease in inflationary expectations, followed by and expansionary fiscal

policy.



14. In the figure below, which of the following could explain the shift downwards of the

AS curve?

a. An increase in inflationary expectations.

b. An increase in oil prices.

c. A fall in inflationary expectations.

d. An increase in government spending.


15. If the Fed pursues contractionary monetary policy, what are the effects in the

medium run (once people’s inflation expectations have had time to adapt)?

a. AD shifts down/left.

b. AD shifts down/left and AS shifts down.

c. AD shifts up/right.

d. AD shifts up/right and AS shifts up.

e. AD shifts down/left and AS shifts up.

16. According to classical theory, the aggregate supply (AS) curve is:

a. perfectly horizontal

b. gently upward sloping

c. flat at first, and then rises steeply

d. perfectly vertical

e. downward sloping


17. Which of the following statements does not characterize classical theory?

a. Markets are self-adjusting, and the economy tends to function smoothly.

b. Individuals are rational, optimizing agents, who quickly respond to market

conditions.

c. Output always remains at its full employment level.

d. Fiscal and monetary expansion tends to lead to higher inflation.

e. The government should intervene to keep market conditions favorable for

corporations to maximize profits.

18. Which of the following statements characterizes Keynesian theory?

a. Individuals are not always rational, optimizing agents, but instead are subject to

waves of optimism or pessimism.

b. The “animal spirits” of investors can lead to big fluctuations in the business cycle.

c. The AD curve is perpetually on the move over the peaks and troughs of the

business cycle.

d. Governments should intervene to smooth out the peaks and troughs of the

business cycle and keep the AD curve more stable.


19. The macroeconomic AS/AD model illustrates the following points about the

economy:

a. Expansionary fiscal and monetary policies tend to push the economy toward

higher output.

b. Contractionary fiscal and monetary policies tend to push the economy

toward higher output.

c. Adverse supply shocks lower output and raise inflation.


e. (b) and (c) only.

20. Which of the following are current schools of macroeconomics (see Appendix)?

a. rational expectations school

b. neoclassical synthesis

c. New Keynesian macroeconomics

d. post-Keynesian macroeconomics

e. All of the above are current schools of macroeconomics



1. aggregate demand

2. real wealth

3. real money supply

4. aggregate supply curve

5. maximum capacity

6. wage-price spiral

7. wage and price controls

8. supply shock

9. stagflation

10. inflationary expectations

11. (In Appendix) real business cycle theory

12. (In Appendix) rational expectations school

13. (In Appendix) neoclassical synthesis

14. (In Appendix) New Keynesian macroeconomics

15. (In Appendix) Post-Keynesian macroeconomics

16. False. There will be some unemployment (transitory unemployment) at the full

employment range of output, but not enough unemployment to be considered a problem.

17. True.

18. False. Though there seems to be an inverse relationship between unemployment

rate and inflation rate as suggested by the Phillips curve, this is not always true.

During the 1970s, the United States experienced both high inflation and high

unemployment (stagflation).

19. False. It is the combination of stagnation and inflation.

20. True.

21. The AD curve is downward sloping due to the Fed reaction rule: when inflation is

rising, the Fed will raise interest rates, thereby lowering output, and vice versa when

inflation is falling. Thus higher rates of inflation lead to lower rates of output, and vice

versa. Other explanations for the downward sloping AD curve include real wealth effect

(lower consumption due to a decline in the value of people’s savings and wealth caused

by inflation), real money supply effect (decline in real money supply, increase in interest

rates and a decline in investment caused by inflation), and a decline in net exports due to

an increase in the price of domestic goods.

22. The AD curve would shift with changes in: levels of government spending,

taxation, autonomous consumption, autonomous investment, and net exports, and with a

change in the Fed inflation rate target.


23. The five regions are: maximum capacity output, the wage price spiral, the full

employment range of output, recession or recovering from recession, and deep

recession where output is far below the full employment level and inflation starts

to drop or may even be negative.

24. Because producers start to encounter bottlenecks in the supply of some of

resources as they increase production, prices will rise in some sectors, leading to

some aggregate increase in inflation.

25. The AS curve is flat in the recession range because the existence of unemployed

resources produces no pressure for inflation to rise, and the stickiness of wages and

prices (their tendency to be slow in adjusting downwards) produces little pressure for

inflation to fall.

26. There is no immediate response to inflation in the short run, because it takes time for

people to notice the higher inflation and to incorporate it into their contracts.

27. Shifts in the AS curve are caused by: changes in inflationary expectations, and

supply shocks (whether beneficial or harmful) such as changes in the price of a key input,

or changes in productivity.

28. The classical AS curve is perfectly vertical because the economy is always at its

full employment equilibrium. If output falls below full employment equilibrium,

unemployed workers would bid down wages, and the economy would thereby return to

full employment. Likewise, if output were to rise above full employment equilibrium,

workers would bid up wages, and the economy would again return to full employment.

29. The composition of spending entails both the types of goods and services produced,

as well as the production methods used in generating GDP. Remember from our

discussion in Chapter 1 that ‘what’ is produced and ‘how’ it is produced are central to

understanding how the production process affects well-being.

30. Some economists operating with a classical/Keynesian synthesis would see the

differences merely as a matter of time. The New Keynesians would be among them, who

would argue that it could take a significant amount of time to reach the long run full

employment equilibrium. Post-Keynesians, on the other hand, would see a much more

fundamental difference between the two approaches. Their starting point is not the

rational, optimizing behavior of individuals and markets that are smoothly functioning.

Rather, they see the economy as unstable and unpredictable, with individuals influenced

by waves of optimism or pessimism.


Answers to Problems

1.

A: Inflation rate

B: Recession

C: Wage-Price Spiral

D: Aggregate Supply

E: Maximum Capacity

F: Output (Y)

G: Y* (Full employment output range)

H: deep recession and decline in inflation

2.

a. Business confidence rises as firms expect an increase in GDP, sales, and profits.

2b. A rise in inflation increases people’s expectations of inflation in the medium run.


2c. The distribution of high speed internet to rural areas boosts productivity.

3a. Government spending for the Vietnam War during 1964-69 pushed up the rate of

inflation from about 1% to 5% -- shown by an upward shift in the AD curve.

Infl

atio

n r

ate

(∏

)


3b. In 1973-74, OPEC engaged in an oil embargo, causing an increase in oil prices.

Inflation rose to above 9% in 1975, and the unemployment rate rose above 8% -- shown by

an upward shift in the AS curve.

c. After another oil price shock in 1979, the Fed conducted a contractionary monetary

policy (choosing a lower target inflation rate). Inflationary expectations fell. The

unemployment rate rose to almost 10%, but inflation fell from 9% to 4% -- shown by a

leftward shift in the AD curve combined with a downward shift in the AS curve.


d. The 1990s brought an era of innovation, increasing global competition, and weakened

unions from years of anti-union government policies. By 1998, the unemployment rate

was 4.4% and inflation was 1.6% -- continual beneficial supply shocks leading to a

downward and rightward shift of the AS curve and the economy’s maximum capacity.


1. E 11. D

2. D 12. D

3. E 13. C

4. B 14. C

5. D 15. B

6. D 16. D

7. C 17. E

8. D 18. E

9. D 19. D

10. A 20. E

Chapter 14 – The Global Economy and Policy 1

Chapter 14

THE GLOBAL ECONOMY AND POLICY Macroeconomics in Context (Goodwin, et al.) Chapter Overview

This chapter will take you through the basics of international trade and finance. The

chapter introduces you to recent trends in the flows of trade and finance, as well as to the

controversies over globalization. Imports and exports are added to the circular flow

diagram that was introduced in Chapters 9 and 10. The chapter discusses the ways in

which trade impacts fiscal and monetary policy. You will learn about exchange rates as

well as different exchange rate systems. The chapter also examines the real world

political economy of international economic relations.

Objectives


1. Describe various ways in which national economies are economically interconnected.

2. Understand the major policy tools countries have used to manage the degree of

“openness” of their economies.

3. Describe major recent developments in the volume of international trade and financial

flows.

4. Explain the macroeconomic impact of imports and exports using the circular flow

model.

5. Understand basic principles of international finance.

6. Understand the implications of “openness” for monetary and fiscal policies.

7. Identify important international institutions concerned with trade and finance.

Key Terms protectionism

trade quota

tariffs

non-tariff barriers to trade

trade-related subsidies

import substitution

capital controls

domestic content requirements

foreign trade zone

migration controls

free trade area

customs union

common market

World Trade Organization (WTO)

trade deficit

purchasing power parity (PPP)

exchange rate

purchasing power parity (PPP) adjustments

currency depreciation

currency appreciation

real exchange rate

foreign exchange

balance of payments (BOP) account

current account (in the BOP account)


trade account

capital account (in the BOP account)

portfolio investment

foreign direct investment (FDI)

capital flight

official reserve account

flexible (floating) exchange rate system

fixed exchange rate system

Bretton Woods system

devaluation

revaluation

foreign exchange market intervention

balance of payments crisis International Monetary Fund (IMF)

fiscal capacity

World Bank

Washington Consensus

Active Review

Fill in the Blank

1. Suppose the U.S. government puts a tax on the imports of steel produced abroad.

Such taxes charged on imports or exports are called .

2. Policies that provide subsidies to domestic producers to encourage the production

of goods for domestic market and reduce the quantity of imports are called

____ policies.

3. Countries sometimes set up ____________________ within their borders, where foreign-owned manufacturers can operate free of many taxes, tariffs, and regulations.

4. ________________ refer to the regulation or taxation of international transactions

involving financial assets.

5. The exchange rate between two currencies, when adjusted for inflation in each

country, is known as the ____________________.

6. A _______________________ can occur when a country gets precariously close to

running out of foreign exchange and is therefore unable to purchase imports or service

its existing debt.

7. The notion that, under certain idealized conditions, the exchange rate between the

currencies of two countries should be such that the purchasing power of currencies is

equalized is called .

8. The national account that tracks inflows and outflows arising from international trade,

earnings, transfers, and transactions in assets is called the .

9. The account that tracks flows arising from international transactions in assets is called

the .

10. Under a fixed exchange system, if a government lowers the value at which it fixes its

exchange rate, the currency will undergo a .


True or False

11. Both quotas and tariffs provide a monetary revenue benefit to the government that

has imposed them.

12. When a currency becomes less valuable in a flexible (floating) exchange rate system

the correct term to use is “devaluation.”

13. When foreigners buy U.S. bonds or invest in a U.S. business, these are capital

outflows in the balance of payments account.

14. The fixed exchange rate system of Bretton Woods broke apart in 1972, when the

U.S. dollar came under too much selling pressure.

15. Under a fixed exchange rate system, it becomes impossible for an individual country

to conduct independent monetary policy (as exemplified by the case of the EU countries

that have adopted the euro).

Short Answer

16. List three policy tools to regulate trade in goods and services.

17. Identify and describe each of the three leakages and the three injections in the open

economy version of the circular flow model.

18. Explain the difference between “depreciation” and “devaluation.”

19. Explain how a foreign exchange market intervention could be used to protect a

currency that market forces are pushing toward a potential devaluation. Under what

circumstances would this intervention potentially turn into a balance of payments crisis?

20. Explain what is meant by purchasing power parity (PPP), and purchasing power

parity (PPP) adjustments.


21. Explain what happens to the value of the currency when there’s an increase (or

decrease) in the supply (or demand) of the currency in a foreign exchange market with

flexible exchange rates. 22. Explain what is meant by the balance of payments account, the current account (in

the BOP account), and the capital account (in the BOP account). 23. Describe the impact of an expansionary monetary policy in an open economy.

24. Why do some countries try to control the value of their currencies through a fixed

exchange rate system? And how can they do so? 25. How has the adoption of the euro affected monetary policy-making in the

Eurozone countries?

26. What are the international institutions of the “Washington Consensus”, and what

were the policy prescriptions they imposed on many developing countries in the 1980s

and 1990s?


Problems

1. Identify whether each of the following represents an inflow or an outflow from either the current account or the financial account:

a. A Mexican banker purchases a United States government bond.

b. A U.S. corporation invests in a Chinese facility.

c. A U.S. corporation collects profits earned in Mexico and sends the money back to United States.

d. An exporter in the U.S. receives payment for goods shipped to France.

e. The U.S. government pays interest to bondholders in China

2. Exchange rates

a. Suppose under a flexible exchange system, there is a drop in the demand

for the U.S. dollar, as investors find higher returns in countries that use the

Euro. Use a graph of the foreign exchange market, with the price of

dollars expressed as “Euros per dollar” to illustrate the impact on the value

of the dollar.

b. Suppose that under a fixed (or managed) exchange system, China strives

to keep the value of its Yuan artificially low. Illustrate with a graph of the

foreign exchange market, how China’s Central Bank can do this.


Self Test

1. Which of the following is not one of the policy tools to regulate trade in goods and

services?

a. Import quotas

b. Tariffs

c. Licensing requirements on imports

d. Capital controls

e. Trade-related subsidies

2. Suppose Hereland puts a quota on imports of oranges from Thereland. Which of the

following groups is most likely to reap financial benefits from the imposition of the

quota?

a. Hereland’s orange producers

b. Hereland’s government

c. Thereland’s government

d. Hereland’s consumers


3. Which of the following characterizes the trends in trade and financial flows for the

U.S. in recent years?

a. The volume of trade in goods and services (as a % of GDP) has increased over

time, from about 10% in 1965 to almost 30% in 2015.

b. China has emerged as a major source of U.S. imports.

c. The volume of financial flows has increased significantly in recent years.

d. Since the early 1980s, the U.S. has been running current account deficits, mostly

due to the trade deficits.


4. Which of the following is not one of the top buyers of U.S. exports?

a. Canada

b. Mexico

c. China

d. Japan

e. France

5. Which of the following is not one of the top sellers of imports to the United States?

a. Canada

b. Mexico

c. Brazil

d. China

e. Japan


6. The circular flow model in this chapter frames aggregate expenditure as:

a. AE = Consumption + Intended Investment + Taxes + Exports

b. AE = Consumption + Actual Investment + Government Spending + Exports -

Imports

c. AE = Consumption + Actual Investment + Government Spending - Taxes +

Exports

d. AE = Consumption + Intended Investment + Government Spending + Net

Exports

e. None of these accurately describes aggregate expenditure.

7. Which of the following best describes trends in trade expressed as a percentage of

production from 1960 - 2015?

a. both the worldwide volume of trade grew and the U.S. volume of trade grew

b. the worldwide volume of trade grew while the U.S. volume of trade fell

c. the U.S. volume of trade grew while the worldwide volume of trade fell

d. both the worldwide volume of trade fell and the U.S. volume of trade fell


8. Suppose that the exchange rate between U.S. dollars and currency in France, the euro,

is 1.25 dollars per euro. If purchasing parity holds, how much would we expect a bottle of

perfume that costs €100 in France to sell for in the United States?

a. 80 dollars

b. 100 dollars

c. 120 dollars

d. 125 dollars

e. 150 dollars

9. Suppose that the exchange rate between U.S. dollars and currency in Mexico, the peso,

is 0.10 dollars per peso. If purchasing parity holds, how much would we expect a scooter

that costs $10,000 in the United States to sell for in Mexico?

a. 1,000 pesos

b. 10,000 pesos

c. 20,000 pesos

d. 50,000 pesos

e. 100,000 pesos


10. Suppose the German demand for United States stocks increases due to a stock market

boom in the U.S. What would we expect to happen in the foreign exchange market, holding

all other factors constant?

a. The dollar will depreciate and more dollars will be traded.

b. The dollar will depreciate and fewer dollars will be traded.

c. The dollar will appreciate and more dollars will be traded.

d. The dollar will appreciate and fewer dollars will be traded.

e. The dollar could appreciate or depreciate, but fewer dollars will be traded.

11. Suppose the Chinese demand for United States government bonds decreases due to

concerns about political battles in Washington D.C. What would we expect to happen in

the foreign exchange market, holding all other factors constant?

a. The dollar will depreciate and more dollars will be traded.

b. The dollar will depreciate and fewer dollars will be traded.

c. The dollar will appreciate and more dollars will be traded.

d. The dollar will appreciate and fewer dollars will be traded.

e. The dollar could appreciate or depreciate, but fewer dollars will be traded.

12. In 2012, brokers selling Miami real estate found that some of their best clients were

from Argentina. What concept does this story from the chapter provide an example of?

a. foreign exchange market intervention

b. portfolio investment

c. capital flight

d. foreign direct investment


13. Assume a foreign exchange market with a flexible exchange system. Suppose the

demand for a country’s currency decreases. This results in a

currency.

a. depreciation

b. appreciation

c. devaluation

d. revaluation

e. The value of the currency will remain unchanged.

in its


14. If the value of a country’s currency falls, what is the effect on exports and imports,

assuming all else remains unchanged?

a. Exports will fall, and imports will rise.

b. Exports and imports will both fall.

c. Exports will rise, and imports will fall.

d. Exports and imports will both rise.

e. Exports and imports will remain unchanged.

15. How would payments from the sale of fighter jets to Saudi Arabia be registered in

the U.S. balance of payments?

a. As an inflow in the current account.

b. As an outflow in the current account.

c. As an inflow in the capital account.

d. As an outflow in the capital account.


16. Suppose a Kuwaiti company invests in a U.S. bank. How would this transaction be

registered in the balance of payments?

a. As an inflow in the current account.

b. As an outflow in the current account.

c. As an inflow in the capital account.

d. As an outflow in the capital account.


17. Which of the following best describes the impact of an expansionary monetary

policy in an open economy?

a. The rise in the interest rate dampens investment spending. It also raises capital

inflows, raises the demand for and value of the currency, thereby dampening net

exports.

b. The fall in the interest rate stimulates investment spending. It also raises capital

inflows, raises the demand for and value of the currency, thereby dampening net

exports.

c. The fall in the interest rate stimulates investment spending. It also reduces capital

inflows, reduces the demand for and value of the currency, thereby boosting net

exports.

d. The fall in the interest rate stimulates investment spending. It also reduces capital

inflows, reduces the money supply, which raises interest rates, cancelling out the

effects of the initial fall in the interest rate.



18. How can a Central Bank prop up the value of its currency?

a. It could create more demand for the domestic currency by buying more of it.

b. It could increase the supply of the domestic currency.

c. It could create less demand for the domestic currency by buying less of it.

d. It could declare the currency to have a greater value, by fiat.


19. Which of the following is not one of the international institutions established in the

late 1940s?

a. The Bretton Woods system of fixed exchange rates.

b. The World Bank

c. The International Monetary Fund (IMF)

d. The General Agreement on Tariffs and Trade (GATT)

e. The World Trade Organization

20. Which of the following was not one of the policy prescriptions advocated by the

“Washington Consensus” in the 1980s and 1990s?

a. Trade liberalization

b. Privatization

c. Deregulation

d. Reduce the size of government

e. Government spending to reduce poverty



1. tariffs 2. import substitution

3. foreign trade zones

4. capital controls

5. real exchange rate

6. balance of payments crisis

7. purchasing power parity (PPP)

8. balance of payments (BOP) account

9. capital account (in the BOP account)

10. devaluation

11. False. Only tariffs provide a monetary revenue benefit to the government.

12. False. “Depreciation” is the correct term.

13. False. They are capital inflows.

14. True.

15. True.

16. Three policy tools to regulate trade are: a trade quota, a tariff, or a trade- related

subsidy.

17. The leakages in the open economy circular flow model include savings, taxes, and

imports. The injections in the open economy version of this model include intended

investment, government spending, and exports.

18. “Depreciation” refers to the reduction in a currency’s value in a flexible

exchange rate system, while “devaluation” refers to a reduction in a currency’s

value in a fixed exchange rate system.

19. A foreign exchange market intervention to protect a currency threatened with potential

devaluation would involve the central bank buying the threatened currency and

depleting foreign exchange reserves. If the central bank is in danger of running out of

foreign exchange then a balance of payments crisis is a distinct possibility.

20. Purchasing power parity is the theory that exchange rates should reflect the difference in

purchasing power among countries, under certain idealized conditions (such as the free

trade of currencies and goods, and the absence of transportation costs). However, in

reality these conditions often do not exist. Thus purchasing power parity (PPP)

adjustments are made to take account of differences in the cost of living between

countries.

21. If the supply of the currency increases, the value of the currency will fall. If the

demand of the currency increases, the value of the currency will rise. (And vice versa

for the decrease.)

22. The balance of payment account tracks the inflows and outflows arising from

international trade, earnings, transfers, and transactions in assets. It’s divided into two

subsections: the current account and the capital account. The current account tracks

the inflows and outflows from trade in goods and services, as well as earnings and

transfers. The capital account tracks inflows and outflows from transactions in assets.

23. In an expansionary monetary policy, interest rates fall, which stimulates investment

spending. But the lower interest rates also lead to capital outflows, a fall in the

demand for the currency, and thereby a depreciation in the currency and an increase

in net exports. The increase in investment spending and net exports both boost


aggregate expenditure and GDP.

24. Because a wildly fluctuating currency can be very destabilizing in conducting

economic activities (particularly for producers, or people with financial assets). Their

Central Bank can either buy up domestic currency (to prop up its value). Or if it wants

to artificially keep the value of its currency low, it can increase the supply of its

domestic currency on the market.

25. By adopting a common currency, the Eurozone countries have given up having

separate monetary policies and put the European Central Bank in control of their

monetary policy-making. Since the different Eurozone countries have different

objectives and requirements, it is complicated to design a monetary policy that fits the

interest of all member countries. For example, the low interest policies of the ECB

after the 2008-09 financial crisis was not sufficient to boost the economies of countries

like Greece and Spain where the impacts of the crisis was much more adverse than in

countries like Germany and Austria.

26. The “Washington Consensus” consists primarily of the World Bank and IMF, both

located in Washington D.C. As a condition for assistance, they required developing

countries to engage in trade liberalization, privatization, deregulation, and decreasing

the size of government through spending cuts (budget austerity).

Answers to Problems

1.

a. Inflow, financial account This is “borrowing from abroad”

b. Outflow, financial account This is “FDI abroad”

c. Inflow, current account This is “income receipts”

d. Inflow, current account This is “payments for exports of goods”

e. Outflow, current account This is “income payments”


2. a. A drop in demand for the U.S. dollar results in a depreciation in the value of the

dollar.

b. The Chinese Central Bank can increase the supply of the Yuan to keep its value low.


1. D

2. A

3. E

4. E

5. C

6. D

7. A

8. D

9. E

10. C 11. B

12. C

13. A

14. C

15. A

16. C

17. C

18. A

19. E

20. E

S

E2

E1

D1

D2

Euro

s p

er

Do

llar

Depreciationof the Dollar

Quantity of Dollars

S1

E1

E2

D

Do

llars

p

er

Yuan

Depreciation of the Yuan

Quantity of Yuan

S2

Chapter 15 – Financial Instability and Economic Inequality 1

Chapter 15

FINANCIAL INSTABILITY AND ECONOMIC INEQUALITY Macroeconomics in Context (Goodwin, et al.)

Chapter Overview

This chapter discusses some of the complexities of real-world macroeconomics by

introducing you to two of the key challenges of the current century—financial instability

and economic inequality. It begins by reviewing the origins and development of the

financial crisis of 2007-8 and discussing the policy responses. It then explains the

occurrence of such crisis, in general, based on Minsky’s theory of financial instability.

The role of deregulation and financialization in increasing the vulnerability of both the

real and financial sectors in the U.S. economy is discussed in some detail. A description

of some of the key factors contributing to the rising economic inequality in the United

States in recent decades is presented next. The final section makes some

recommendations on addressing macroeconomic instability and economic inequality. The

debate over policy responses continues, and this chapter provides you with the

background you need to assess the current state of macroeconomic policy.

Chapter Objectives


1. Describe the underlying causes of the 2007-08 financial crisis and explain the severity

and impacts of the crisis.

2. Describe the major fiscal and monetary responses to the crisis.

3. Understand the role of deregulation and financialization in increasing the vulnerability

of the real and financial sectors of the U.S. economy.

4. Describe Minsky’s theory of financial instability to explain the occurrence of financial

crisis and understand the role of regulation in managing instability.

5. Understand the similarities and differences between the Great Recession and the Great

Depression.

6. Describe the trends in inequality in the United States in the past few decades.

7. Identify the underlying causes of rising wage inequality and the role of financialization

and macroeconomic policies in contributing to the rise in inequality.

8. Discuss policy measures that might help create a more stable and sustainable economic

system.

Key Terms

subprime mortgage

securitization

mortgage-backed security (MBS)

collateralized debt obligation

moral hazard

credit rating agencies

“too big to fail”

wage-productivity gap

skill-biased technical chang


Active Review

Fill in the Blank

1. The process of pooling various kinds of loans, slicing and sorting them according to

their risk levels, and repackaging them into financial instruments is known as

_________________________.

2. Mortgages given to people with poor credit are known as _______________________.

3. The availability of government bailouts for large firms can encourage excessive risk-

taking, a phenomenon known as ______________________

4. The major financial reform passed in the wake of the 2007-9 crisis was the

_________________ bill.

5. The law formerly separating commercial and investment banking, which was repealed

in 1999, was known as the ________________________

6. The process of increasing size and importance of the financial markets in the operation

of the economy is known as_________________.

7. The theory that unregulated markets will always produce instability and crisis is

referred to as the _________________.

8. In Minsky’s theory, the three financial profiles that account for the different margins of

safety are _________________, _________________, and _________________.

9. The gap between the growth of labor productivity and the growth of wages, referred to

as _________________, has been _________________ since the 1970s.

10. The theory that relative wage gains will be greatest for those workers who possess the

education and skills to use modern technologies is _________________.

11. Since the 1980s, the difference in effective tax rates paid by the rich and the poor has

_________________ with the decline in corporate taxes and an increase in payroll

taxes.

12. A tax on financial transactions is often referred to as ________________________,

after the economist who first proposed it.


True or False

13. High mortgage rates contributed to the development of the housing bubble.

14. Since the 1970s, a greater proportion of money in the financial system has been

directed towards funding productive investment, while investment in financial

instruments have declined.

15. The 2008 crisis was referred to as the “Minsky’s moment” because Minsky’s theory

of financial instability predicted such a crisis.

16. The Great Recession was less severe than the Great Depression because of the

deregulation of the financial system since the 1980s.

17. The expansionary monetary policies implemented by the Federal Reserve since the

1980s have contributed to the rising income inequality in the U.S..

18. The Dodd-Frank bill promoted deregulation of banks.

Short Answer

19. What were some of the factors leading to the housing bubble?

20. What were the major fiscal and monetary policy responses to the crisis?

21. In what ways can unemployment be both a result and a cause of deepening recession?

22. How does Minsky’s theory explain the occurrence of financial instability in the

economic system?

23. What are some of the factors explaining the rise of inequality in the United States in

the past few decades?


24. How was globalization related to increasing inequality?

25. Discuss some of the ways in which financial resources may be directed towards more

socially useful investments.

Problems

1. Refer to Figure 15.2 in the text to describe how interest rates were related to the

development and collapse of the housing bubble.

2. Refer to Figure 15.6 in the text to describe how the distribution of bank assets changed

between 1984 and 2017.

3. As suggested in Exercise 1 in the text, you can find information on housing prices at

The Federal Housing Finance Agency website www.fhfa.gov. To find the required

data, go to www.fhfa/gov/DataTools/Tools and select HPI Motion chart. Then check

off the states you want to view (it is possible to view multiple states at the same time).

Select the third tab at the top right (with graph symbol) to get a historical view of the

rate of change in state housing prices from 1991 to the present. What do you observe?

(Note that the chart shows quarterly rate of change, not absolute price levels, so overall

prices start to fall when the line goes below zero.)

4. As suggested in Exercise 2 in the text, you can find data on the Great Recession at

the Federal Reserve Economic Database http://research.stlouisfed.org/fred2/ To find

data on unemployment rates, go to Current Population Survey/Unemployment

Rate/Civilian Unemployment Rate/Seasonally Adjusted (do not select Natural Rate of

Unemployment on the main Population, Employment, and Labor Markets page – this

does not show total unemployment). Drag the cursor over graph to see the data on

unemployment during the last four recessions. How does the Great Recession compare

to previous recessions?

Self Test

1. Factors contributing to the housing bubble included:

a. Unprecedented access to credit.

b. Rising unemployment.

c. Low interest rates.

d. Both (a) and (b).

e. Both (a) and (c).

http://www.fhfa.gov/

http://www.fhfa/gov/DataTools/Tools

http://research.stlouisfed.org/fred2/


2. During the recession of 2007-9:

a. The U.S. economy lost nearly 9 million jobs.

b. About 11 million homeowners faced foreclosure

c. Manufacturing unemployment rose from 4.3% to 12.1%

d. U.S. consumer spending declined and business profits fell.


3. The underlying causes of the financial crisis of 2007-8 included all of the following

except:

a. Increasing bank size.

b. Increasing inequality.

c. Excessively contractionary monetary policy.

d. Deregulation

e. Short-term corporate incentive.

4. Comparing the Great Depression and the Great Recession, we can say that:

a. The Great Recession was more severe in terms of unemployment .

b. The Great Depression was more severe in terms of unemployment .

c. Both were preceded by bubbles in asset values.

d. Both (a) and (c).

e. Both (b) and (c).

5. Government responses to the 2007-9 recession included all of the following except:

a. Stimulus spending by state and local governments.

b. Bailouts for key financial institutions.

c. Stimulus spending by the federal government.

d. Expansionary monetary policy.

e. “Quantitative easing” or security purchases by the Fed.

6. The Dodd-Frank bill does all of the following except:

a. Sets up a Consumer Financial Protection Bureau.

b. Relaxes bank regulation.

c. Institutes minimum lending standards.

d. Empowers regulators to aggressively pursue financial fraud, conflicts of

interest and manipulation of system.

e. Requires greater disclosure by ratings agencies.


7. Regulations put in place after the Great Depression include all of the following

except:

a. Glass-Steagall Act

b. Dodd-Frank Bill

c. Regulation Q

d. Restrictions on banking across state lines

e. Imposition of several capital and leverage requirements on the financial sector

8. The increase in size of banks since the 1980s is explained by:

a. Loosening of restrictions on capital across borders

b. Riegle-Neal Interstate Banking and Branching Act

c. Financial Services Modernization Act

d. (b) and (c) only

e. (a), (b) and (c)

9. Which of the following statements is TRUE?

a. The frequency of bank mergers increased steadily from 1980 to 2000, and has

declined since then.

b. Deregulation of the financial sectors has helped reduce the risk-taking behavior of

banks.

c. The Dodd-Frank bill reinstituted the separation between commercial and investment

banks.

d. Non-financial firms have become increasingly financialized through increasing

investment in financial instruments.


10. The ‘efficient market hypothesis is based on all the following assumptions except:

a. Individuals are rational decision-makers.

b. Markets are perfectly competitive.

c. Individual decision-making is influenced by their expectations.

d. Individuals possess complete information about the market price of assets.

e. (a) and (c)

11. According to Minsky, during an economic expansion

a. financial firms move from speculative financing to hedge financing.

b. financial firms become more confident and take higher risks.

c. financial firms move from hedge financing to Ponzi financing.

d. financial firms become stronger.

e. Both (b) and (c).



a. Data from 1948 to 2017 shows that corporate profits have always grown faster

than wages.

b. Over time, the labor productivity in the U.S. has declined.

c. The wage-productivity gap has narrowed in the last three decades.

d. Union membership rate in the U.S. has gradually increased since the 1970s.


13. The theory of skill-biased technological change proposes that:

a. relative wage gains will be the greatest for workers who possess the education

and skills to use modern technologies

b. technological change leads to a decline in wages

c. technological change increases worker productivity and their wages

d. as technology replaces workers, the bargaining power of workers declines

e. technological change could increase unemployment rates

14. Which of the following explains financialization as a factor in rising inequality in

the U.S. economy?

a. Wages in the financial sector has grown much faster than wages in other

sectors.

b. A greater share of income has gone to those who own assets, most of whom

tend to be wealthier individuals.

c. Executive pay has increased sharply due to a change in corporate pay structure,

where a larger proportion of executive pay has come in the form of stock

options and bonuses.

d. Workers’ bargaining power has declined as corporations have shifted their

reliance on earnings through financial channels.


15. Since the 1980s,

a. top marginal tax rates have increased.

b. payroll tax rates have declined.

c. effective tax rates paid by the rich and poor has narrowed.

d. spending on welfare has increased.



16. An expansionary monetary policy could increase inequality because:

a. low interest rates increase asset prices which are mostly owned by the rich

b. low interest rates increase labor income faster than business income

c. middle-income savers lose returns on savings when rates are low


e. (a), (b), and (c).

17. Which of the following statements about the impact of macroeconomic policy on

inequality is TRUE?

a. The impact of fiscal policies of the last few decades on inequality is

ambiguous.

b. Fiscal policies of the last few decades have contributed to a rise in inequality.

c. Monetary policies of the last few decades have contributed to a rise in

inequality.

d. The impact of fiscal policy on increasing inequality is less clear than the

impact of monetary policies.

e. There is clear evidence that the equalizing effects of monetary policy is greater

than its disequalizing effects.

18. Policies to reduce inequality include all the following, except:

a. Lowering corporate taxes.

b. Increasing minimum wages.

c. Strengthening labor unions.

d. Increasing investment in human capital.

e. Providing support to low-income workers.

19. Which of the following might help direct financial resources to more socially

useful investments?

a. Increasing payroll taxes.

b. Encouraging companies to engage in stock buybacks.

c. Promoting regional and community financial institutions.

d. Increasing investment in financial assets.


20. Proposals for regulate the financial system include:

a. A financial transactions tax.

b. An increased sales tax.

c. A lower sales tax.

d. A general reduction in business taxes.

e. A general increase in business taxes.



1. securitization

2. sub-prime mortgages

3. moral hazard

4. Dodd-Frank

5. Glass-Steagall Act

6. financialization

7. financial instability hypothesis

8. hedge, speculative, and Ponzi

9. wage-productivity gap, increasing

10. skills-biased technical change

11. narrowed

12. Tobin tax

13. False. It was low mortgage rates that feed the growth of the housing bubble.

14. False. Role of finance in funding productive investment has declined while a greater

portion of money has gone to investment in financial instruments.

15. True.

16. False. The Great Recession was less severe than the Great Depression because of the

existence of government regulations, automatic stabilizers, and the imposition of

expansionary monetary and fiscal policy during the 2008 crisis.

17 False. The impact of monetary policy on inequality is not clear.

18. False. The goal was to regulate the banks, though it has been watered down to a great

extent through intense lobbying by the financial sector.

19. Factors leading to the housing bubble included a period of low interest rates,

unprecedented expansion of credit including sub-prime mortgages, and speculation in

the housing market driving prices even higher.


20. After the immediate responses of bailouts for endangered financial institutions, the

Federal government instituted large-scale stimulus spending to prevent a collapse in

aggregate demand and to promote economic recovery. At the same time, the Federal

Reserve engaged in an extraordinarily expansionary monetary policy, purchasing

hundreds of billions of dollars’ worth both of Treasury bonds (traditional expansionary

policy) and other financial assets (“quantitative easing”).

21. As the economy goes into recession, more people are laid off. Unemployed workers

have less income to spend, leading to a decline in consumption. This lowers business

profits, which in turn promotes further cutbacks and layoffs. The process creates a

vicious spiral of unemployment and lower consumption that feeds on itself and deepens

the recession.

22. Minsky’s theory argues that uncertainty about the future and expectations of market

participants play a key role in influencing the value of assets. When the economy is just

recovering from a crisis investors will be cautious and maintain large safety margins.

However, as the economy gains strength, investors will become more optimistic and

pursue risky ideas which weakens the financial system and makes it more credit-

dependent and vulnerable to crisis.

23. Rising wage-productivty gap due to decline of unions, globalization and trade, and

technological change. The financialization of the economy and the fiscal policies of the

past few decades have also contributed to the rise in inequality.

24. Globalization has lowered the bargaining power of workers as corporations have

had to ability to look around the world and also relocate their production facilities to

hire low-cost workers (mostly in developing countries). Additionally, competition from

low-priced imports has also eliminated many jobs, especially in the industrial sector,

and pushed many middle-income workers to move to lower-income jobs.

25. Promoting smaller regional and community financial institutions that support local

home-buyers and businesses. Institute small tax on financial transactions to discourage

speculations and prevent the formation of asset price bubbles. Restrict companies from

buying back their own stocks and encourage them to invest in their employees through

tax incentives. Encourage cooperative based organizations that focus on improving the

well-being of workers.


Answers to Problems

1. A steep decline in interest rates after 2001 contributed to inflating the bubble in

housing prices. The fact that interest rates rose in 2005 and 2006 may have been a

precipitating factor in the bursting of the bubble. Once the bubble burst, with a steep

decline in housing prices, interest rates also fell as the Fed moved back to an

expansionary policy to respond to the crisis and ensuing recession.

2. Bank assets became increasingly concentrated in the largest banks, with the share of

assets held by banks with assets over $250 billion went from about 5% to over 50%

between 1996 and 2017. The relatively large banks with assets between $10 billion and

$250 billion increased from being less than 30% in 1984 to almost 50% between 1994

and 2000, and then declined to just over 30% in 2017. Meanwhile the share of the

smallest banks, those with less than $100 million in assets, fell from about 14% to

about 0.5% between 1984 and 2017. The shares of intermediate-sized banks also

declined, with the share of banks having assets between $100 million and $1 billion

going from about 26% to about 7%, and the share of banks having between $1 and $10

billion going from about 32% to about 10% between 1984 and 2017.

3. In general, all states show the pattern of a housing price run-up prior to 2006, with a

significant price crash by 2008. After 2008, the rate of decline slows, but the rate of

change remains below zero for most states until 2011. The fluctuations are more

extreme for states such as Florida and Nevada than, for example Connecticut and

Illinois, indicating that the crisis was concentrated in specific housing markets (but, as

the text notes, spread nationwide due to the complexity of mortgage finance

instruments).

4. The Great Recession was much more severe than the previous three recessions, with

an increase in unemployment of over five percentage points. The FRED graph also

shows that unemployment continued to rise after the formal end of the recession, then

declined only slowly, falling below 7% only at the end of 2013, and falling even lower

to about 4% in 2017.


1. E 11. E

2. E 12. E

3. C 13. A

4. E 14.E

5. A 15. C

6. B 16. D

7. B 17. B

8. E 18. A

9. D 19. C

10. C 20.A

Chapter 16 – Deficits and Debt 1

Chapter 16

DEFICITS AND DEBT Macroeconomics in Context (Goodwin, et al.)

Chapter Overview

This chapter expands on the material from Chapter 10, from a less theoretical and more

applied perspective. It begins by going over the difference between deficits and debts,

and reviewing some of the history of U.S. indebtedness. Included in this is a brief

discussion of “supply-side” economics and its role in altering the fiscal position of the

United States. The chapter also goes into significant detail explaining the differences

among different debt “terminologies” that are often confused, clarifying what we mean

by terms such as “external debt” or “public debt.” It then reviews some of the basic

problems with excessive borrowing, including political considerations and issues related

to the foreign holding of government debt. This discussion includes a contrast between

the European Union (EU) and US approaches to their respective budget problems. The

chapter concludes with future projections of deficits and debt in the United States, and a

discussion of some policies to reduce future deficits and long-term growth of debt.

Chapter Objectives


1. Understand the difference between a deficit and a debt, and how the two are related.

2. Explain how the national debt in the United States has evolved over the years.

3. Have a basic understanding of how “supply side” economics changed the debt

situation in the United States.

4. State the differences among the different debt classifications

5. Understand the main problems with excessive borrowing

6. Explain the different ways in which a country’s debt infiltrates its politics, both

domestic and international.

7. Explain what future projections are, both for U.S. deficits and debt.

8. Discuss the revenue and spending side policies for reducing future deficits.

Key Terms

gross federal debt

debt held by the public

internal debt

external debt

monetizing the debt

deficit ceiling

debt ceiling

functional finance

sovereign debt

convergence criteria

austerity


Active Review

Fill in the Blank

1. We say that whereas the government deficit is a flow variable, the debt is a ________

variable.

2. The gross federal debt results from an accumulation of _____________ over the years.

3. The Department of the Treasury issues ___________ in order to pay for its budget

deficits.

4. President Reagan favored policies based on _____________ economics, which

presumed that offering more benefits to the rich would help the economy.

5. The _____________ debt refers to the total amount owed by the federal government to

all claimants.

6. When the Federal Reserve buys the government debt as it is issued, it is referred to as

_________ the debt.

7. Were it not for low _____________ in recent years, the growing debt would have been

a greater burden on the annual federal budget.

8. The two countries that hold the greatest share of the U.S. gross federal debt are

_______ and _______.

9. A policy of ________ involves cutting deficits by cutting social spending and/or

raising taxes.

10. The rules by which EU member countries must abide as a condition for participating

in the Eurozone are known as the _____________.

True or False

11. An accumulation of government debts will ultimately lead to a deficit.

12. Alexander Hamilton believed that the national debt had the potential to strengthen the

country.

13. The debt held by the public refers to the portion of the debt not held by foreign

countries.

14. China holds a minority of the external debt of the United States.


15. The United States recently passed a balanced budget amendment to the Constitution.

16. United States policy has, over the past 10 years, preferred deficit spending to

austerity.

Short Answer

17. Explain the difference between deficits and debt, and discuss how they are related.

18. Has the federal debt increased over the past century in absolute terms? How about as

a percentage of GDP? Discuss.

19. Explain how supply-side economic policies have impacted the U.S. federal budget.

20. Discuss in detail how ‘gross federal debt’ is different from ‘total U.S. indebtedness.’

21. What are some of the main problems associated with too much borrowing by the

federal government?

22. Many believe that most of our government debt is owed to foreigners, especially to

the Chinese. Is this true? Discuss.

23. Should the United States “balance its budget?” Discuss, contrasting the United States

and the European Union.

24. What does the future hold for the U.S. federal budget? Why, according to the

Congressional Budget Office, are deficits likely to increase significantly in the next few

years?


25. Do taxes on carbon or other greenhouse make sense from the standpoint of reducing

U.S. deficits? Explain.

Problems

1. Given the following hypothetical budget data for “Budgetland,” fill in the “total

spending” column (which, for the time being, is just military and civilian spending). Then

calculate the surplus/deficit for each year and, based on this calculation, the existing debt

at the start of the next year. Comment.

Year

Tax

Revenue

Military

Spending

Civilian

Spending

Total

Spending

Surplus or

Deficit

Existing

Debt

2015 7.0 4.0 4.0

100.0

2016 7.2 4.0 4.1

2017 7.2 4.2 4.3

2018 7.3 4.0 4.5

2019 7.0 3.7 4.7

2020 7.1 3.5 4.9

2021 6.8 3.6 5.1

2022 7.0 3.7 5.3

2023 7.2 3.8 5.5

2024 7.3 3.9 5.7

2025 7.4 4.0 5.9

2. Now expand this problem by adding a column that includes Budgetland’s interest

payments (another component of total spending). For now, assume a constant interest rate

of 2 percent, so that interest payment for the first year equals .02 times the existing debt

of 100.0. (Interest payments for subsequent years will be based on updated debt

numbers). Notice that the debt numbers will themselves change now since the interest

payments will add to the annual deficit. Comment on what you observe.

3. Now let’s compare Budgetland’s debt to its GDP. Add two columns—GDP, and “debt-

GDP ratio.” Let GDP in the year 2015 equal 200.0, and assume that it grows by 3 percent

annually. Then calculate the debt-GDP ratio for each year. What trend do you notice?

4. Finally, redo the entire exercise assuming an interest rate of 5 percent instead of 2

percent. Then try it assuming an interest rate of 10 percent. What differences do you

notice? Prepare a graph that shows the Budgetland’s debt-GDP ratio under each of the

three interest rate assumptions over the period.


Self Test

1. A deficit in a given year signifies…

a. a shrinking surplus.

b. a growing debt.

c. a surplus in the year to follow.

d. higher taxes.

e. Both (a) and (b)

2. Which of the following is NOT an argument for not worrying about the size of the

debt?

a. Every country’s government is indebted.

b. Half of government debt is owed to U.S. citizens.

c. The U.S. government pays interest in dollars, a desirable currency internationally.

d. Government debt never even has to be paid off.

e. All of the above are valid arguments.

3. Our national debt as a percentage of GDP reached its highest point during…

a. the Viet Nam war.

b. the Great Depression.

c. the Reagan Administration.

d. World War II.

e. the Obama Administration.

4. What was the importance of the Great Depression in relation to the history of the U.S.

federal debt?

a. It thereafter became more manageable than it had been previously.

b. Higher taxes since then have wreaked havoc with the federal budget.

c. Social spending started to make a meaningful impact on the overall debt.

d. It was from this point forward that the Treasury Department would start

borrowing at lower interest rates.

e. None of the above is true.

5. Reagan’s 1981 Economic Recovery Act…

a. substantially reduced income and corporate tax rates.

b. was in keeping with his preferred supply-side policies.

c. contributed to a sizable increases in federal budget deficits.

d. coincided with an increased in military spending.

e. All of the above are true.


6. Which of the following was NOT a factor in the record deficits seen during President

Obama’s first term in office?

a. The Great Recession

b. Automatic stabilizers

c. Wars in Iraq and Afghanistan

d. Tax increases

e. All of the above were factors.

7. The “debt held by the public” refers to…

a. the gross federal debt minus the debt held by the Federal Reserve.

b. the gross federal debt minus the debt owed to other government accounts.

c. the gross federal debt plus the debt held in credit cards and household mortgages.

d. the portion of the federal debt held by U.S. citizens.

e. household credit card and mortgage debt.

8. Total U.S. indebtedness, including both public and private debt, reached _____

percent of GDP in the aftermath of the financial crisis of 2007-08.

a. 500

b. 140

c. 350

d. 57

e. 18

9. Monetizing the debt means that…

a. the Fed buys new government debt as it is issued.

b. the Treasury Department issues new bonds to finance the federal budget deficits.

c. the Defense Department sells some of its aircraft for cash in order to help finance

the deficit.

d. the Fed “cashes in” its debt holdings.


10. The Federal Reserve holds approximately _____ percent of the gross federal debt.

a. 10

b. 20

c. 5

d. 50

e. 2


11. After China and Japan, the three single greatest foreign holders of U.S. federal debt

are…

a. Brazil, India, and Russia.

b. Russia, India, and Saudi Arabia.

c. Brazil, Switzerland, and the Congo.

d. Brazil, Russia, and Kenya.

e. Ireland, Brazil, and Switzerland.

12. As of 2016, the EU nation with the greatest debt-GDP ratio was…

a. Portugal.

b. Germany.

c. Greece.

d. Spain.

e. Italy.

13. Austerity…

a. means that deficits are cut through either spending cuts or tax hikes.

b. accurately describes recent U.S. fiscal policy.

c. tends to cause deficits to rise rapidly.

d. describes a set of policies that a government would pursue if it wanted to promote

job growth.

e. was favored by the Reagan Administration.

14. The Congressional Budget expects U.S. deficits to…

a. decline until 2025 and rise steeply thereafter.

b. rise until 2025 and then decline steeply thereafter.

c. decline until the debt is fully paid off by 2055.

d. more or less stabilize by 2025.

e. rise to about 5% of GDP by 2022 and remain close to 5-6% for the next six years.

15. The debt ceiling refers to…

a. the debt level at which the U.S. government runs out of money.

b. the congressionally mandated limit on the size of the federal debt.

c. the point at which the federal debt reaches 100 percent of GDP.

d. a limit on federal debt imposed by the Treasury Department.

e. the point at which interest payments on the debt fully exhaust next year’s budget.


16. A balanced budget amendment to the Constitution…

a. would likely increase the annual inflation rate.

b. would probably make fiscal policy a more powerful tool.

c. was passed in 2013 but awaits ratification.

d. All of the above are true.

e. None of the above is true.

17. Which of the following is NOT a reason given by the CBO for its expectation that

deficits in the United States will remain high in the near future?

a. An increase in healthcare costs.

b. An aging population.

c. An increase in interest payments on the federal debt.

d. The 2017 tax cuts by the Trump administration.

e. All of the above are reasons given by the CBO.

18. The reduction in “mandatory” spending would require the federal government to cut

spending on …

a. the military.

b. retirement programs and unemployment.

c. education and research and development.

d. the environment.


19. Which of the following is a revenue side policy for reducing future deficits?

a. lowering payroll taxes

b. imposing new, possibly environmentally-oriented, taxes

c. reducing spending on military.

d. repealing tax cuts for high-income individuals and corporations

e. Both b. and d.

20. The spending side policies on reducing deficits include all the following, except:

a. increasing taxes for high-income individuals

b. reducing spending on social welfare programs

c. reducing discretionary spending on military and infrastructure

d. increase efficiency of spending on healthcare

e. reduce spending on scientific research



1. stock

2. deficits

3. bonds

4. supply-side

5. gross federal

6. monetizing

7. interest rates

8. China, Japan

9. austerity

10. convergence criteria

11. False, it is the other way round—an accumulation of deficits results in a debt.

12. True

13. False, that would be the internal debt. The public debt refers to the gross federal debt

minus the debt owed to other government accounts such as Social Security and

Medicare.

14. True

15. False, only a minority of Congress members believes that the United States should do

so.

16. True

17. A deficit occurs whenever available tax revenue is insufficient to finance government

spending for that year. The money borrowed by the government to make up the

difference adds to the existing debt. Hence, debt is the accumulation of deficit over

many years.

18. In terms of dollars, yes, the debt has more or less risen throughout the 20th century, to

its present level of over $21 trillion. But in relation to the size of the economy

(GDP)—which is what we care more about—it has fluctuated considerably. It

reached its highest point, more than 100 percent of GDP, during World War II, but

since then declined to under 40 percent in the late 1970s. Since then it has again been

on the rise, recently again reaching over 100 percent of GDP.

19. In short, supply-side economics involves tax cuts—and starting in the 1980s these

were substantial. Reduced tax revenue results in budget deficits (unless spending

declines commensurately, which was far from the case), and with deficits a perennial

phenomenon the debt can become very large indeed.

20. The gross federal debt refers to the total amount of money owed by the federal

government—what is often referred to as the national debt. Total indebtedness is a

much broader concept, which includes the national debt, but also all corporate debt

from financial and non-financial businesses, all debt from state and local

governments, and all debt from households (including credit card and mortgage debt)

and non-profits.

21. One problem is that borrowing sometimes is for “low-multiplier” activities, such as

tax cuts for the wealthy, or spending on projects that might disproportionately benefit

the wealthy, who spend a much smaller share of their income than the poor. Another

problem is that if debt grew too large, creditors might begin to doubt the U.S.

government’s continued ability to finance its debt. Thus far there is not much


evidence of this, but it is not inconceivable. Third, mounting debt requires either that

taxes be raised or that more money be borrowed to finance existing debt. Often this

leads to monetizing the debt—which means that the Fed stands ready to buy the new

bonds—which has monetary policy impacts that might not always be desirable.

22. This is not true. As of 2016, foreigners held about one-third (32.5%) of the debt, of

which the Chinese and the Japanese held over 35 percent. This is not to say that it is

not a problem. Foreign ownership of U.S. debt has increased substantially over the

past 30-40 years, and seems likely to continue increasing. Interest payments on this

portion of the debt must be made to those outside the country.

23. Balancing the budget and, ultimately, paying off the debt would likely create more

problems than it solves. There is nothing inherently wrong with a national

government having a debt, as long as it is “manageable.” What this means is that the

cost of servicing the debt (i.e., paying interest on it) is not too burdensome on the next

budget (in that it requires cuts in other types of spending or an increase in the amount

of borrowing). The problem with balancing the budget is that doing so would require

tax increases, spending cuts, or both. And such policies may have to be implemented

at times when the economy is in a downturn (which might worsen the crisis), or when

there is severe need for government funds for recovery from a natural disaster. So,

while reducing the deficit is probably a good idea, caution is required so that doing so

does not produce too contractionary an effect on the economy. In contrast to the

United States, the European Union had adopted a strict deficit-reducing (austerity)

strategy, which only deepened the already suffering economy with countries such as

Greece, Spain and Portugal experiencing considerable social unrest and economic

hardship. Unfortunately, countries in the Eurozone had little choice, since their deficit

and debt levels must satisfy the euro’s convergence criteria. However, since 2017

these austerity policies have been relaxed and EU has encouraged fiscal expansion.

24. The 2017 tax cuts by the Trump administration that includes tax cuts for everyone,

with greater and more permanent tax cuts going to the high-income individuals and

corporations, is likely to increase the deficits in the coming years significantly.

Moreover, the CBO finds that deficits are likely to remain high—for four other

reasons. First, an aging U.S. population means that more funds than earlier will be

needed to finance retirement programs like Social Security and Medicare, and the tax

base is likely to shrink as the retired become a greater percentage of the overall

population. Second, and related, with health care costs rising much more rapidly than

the general inflation rate, Medicare expenditures will only increase even more

rapidly. Expenditures on Medicaid, a program that provides medical coverage for

poor families, would also increase significantly. Third, federal subsidies for health

care are likely to rise commensurately. Finally, as interest rates are not expected to

remain at historical lows forever, any modest rise in the interest rate would translate

to much larger annual interest payments, also worsening budget deficits.

25. They do make sense, at least potentially. Such taxes increase revenue for the

government, so if nothing else changed, deficits would be smaller, possibly by $100

billion or more. And if such taxes raised sufficient revenue, they could even carry the

additional benefit of allowing a reduction in the income tax, which would likely

increase overall economic efficiency (since instead of taxing income, a “desirable,”

we would tax pollution, an “undesirable.”)


Answers to Problems

1.

Year

Tax

Revenue

Military

Spending

Civilian

Spending

Total

Spending

Surplus or

Deficit

Existing

Debt

2015 7.0 4.0 4.0 8.0 -1.0 100.0

2016 7.2 4.0 4.1 8.1 -0.9 101.0

2017 7.2 4.2 4.3 8.5 -1.3 101.9

2018 7.3 4.0 4.5 8.5 -1.2 103.2

2019 7.0 3.7 4.7 8.4 -1.4 104.4

2020 7.1 3.5 4.9 8.4 -1.3 105.8

2021 6.8 3.6 5.1 8.7 -1.9 107.1

2022 7.0 3.7 5.3 9.0 -2.0 109.0

2023 7.2 3.8 5.5 9.3 -2.1 111.0

2024 7.3 3.9 5.7 9.6 -2.3 113.1

2025 7.4 4.0 5.9 9.9 -2.5 115.4

Budgetland runs a deficit every year, so its debt gradually increases over the period, from

100.0 to 115.4.

2.

Year

Interest

Payment

Total

Spending

Surplus or

Deficit

Existing

Debt

2015 2.0 10.0 -3.0 100.0

2016 2.1 10.2 -3.0 103.0

2017 2.1 10.6 -3.4 106.0

2018 2.2 10.7 -3.4 109.4

2019 2.3 10.7 -3.7 112.8

2020 2.3 10.7 -3.6 116.4

2021 2.4 11.1 -4.3 120.1

2022 2.5 11.5 -4.5 124.4

2023 2.6 11.9 -4.7 128.8

2024 2.7 12.3 -5.0 133.5

2025 2.8 12.7 -5.3 138.5

Including interest payments increase spending each year, which increases the size of the

deficit, and the size of the existing debt for each year.


3.

Year

Existing

Debt GDP

Debt-GDP

Ratio

2015 100.0 200.0 50.0%

2016 103.0 206.0 50.0%

2017 106.0 212.2 49.9%

2018 109.4 218.5 50.0%

2019 112.8 225.1 50.1%

2020 116.4 231.9 50.2%

2021 120.1 238.8 50.3%

2022 124.4 246.0 50.6%

2023 128.8 253.4 50.9%

2024 133.5 261.0 51.2%

2025 138.5 268.8 51.5%

The earlier drop in military spending results in the debt increase not keeping pace with

the 3 percent rate of growth in GDP. This makes the debt-GDP ratio decline slightly and

remain mostly flat until about 2021. After this, continued increased in the interest

payment cause debt to rise more rapidly than GDP, so the debt-GDP ratio increases to

51.5% by 2025.

4.

40%

50%

60%

70%

80%

90%

100%

110%

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Interestrate=2% Interestrate=5% Interesrrate=10%

Increasing the annual interest rate changes matters substantially. Assuming a rate of 5

percent, the debt-GDP ratio is at about two-thirds by 2025, and assuming a rate of 10

percent, debt actually exceeds GDP by the year 2025. This clearly illustrates how the

burden of having to pay interest on existing debt could make it even more difficult to

keep from running deficits (hence borrowing more!) in the future.



1. b

2. a

3. d

4. c

5. e

6. d

7. b

8. c

9. a

10. a

11. e

12. c

13. a

14. e

15. b

16. e

17. e

18. b

19. e

20. a

Chapter 17 – How Economies Grow and Develop 1

Chapter 17

HOW ECONOMIES GROW AND DEVELOP Macroeconomics In Context (Goodwin, et al.)

Chapter Overview

This chapter presents material on economic development and growth, including the theory

behind these concepts, their measurements, and the historical context for understanding

why some countries are successful at promoting development, while others seem to be

“stuck” at low levels of development. You will be able to compare data on growth rates for

different countries in trying to determine whether the world’s poor countries are, over time,

“catching up” to the rich countries. You will also learn about the main institutional factors

that economists consider important in achieving economic development. The chapter

discusses issues of poverty, inequality, and human development; each will allow you to

independently examine the subject matter, and consider its relationship to economic

growth. In the final section, you will learn about the different kinds of economies and the

role of the government in influencing economic outcomes.

Chapter Objectives


1. Explain the difference between “economic growth” and “economic development.”

2. Discuss the relevance of GDP measures and poverty indices in evaluating the

economic progress of countries and regions.

3. Understand the relevance to economics—and to economic growth in particular—of the

Industrial Revolution.

4. Explain the different theories on economic development and understand their historical

context.

5. Describe the various sources of economic growth and development.

6. Describe general patterns of economic growth over time and across different regions

and countries.

7. Discuss the trends in global inequality and the relation between inequality and

economic-well-being.

8. Describe the recent perspectives on development including the Millennium

Development Goals and the Sustainable Development Goals.

9. List the different kinds of economies and their relevance for understanding the process

of economic development and well-being.

Key Terms

human development bilateral development assistance

Capabilities multilateral development assistance

poverty line conditional cash transfer (CCT)

Industrial Revolution unconditional cash transfer (UCT)

dependency theory convergence

primary goods Kuznets curve hypothesis


terms of trade Millennium Development Goals (MDGs)

virtuous cycles (in development) Sustainable Development Goals (SDGs)

capital intensive laissez-faire capitalism

labor intensive administrative capitalism

industrial policy administrative socialism

infant industry market socialism

Active Review

Fill in the Blank

1. When an economy has experienced increases in aggregate levels of production and

income, and its real GDP has risen by some percentage from one year to the next, it has

experienced economic ____________________.

2. When an economy has moved people from a situation of poverty to material plenty

through investments in productive capacity and changes in the organization of work, it

has experienced economic ____________________.

3. The ____________________ approach defines development in terms of the

opportunities that people have to pursue important aspects of well-being, such as being

healthy and having access to education.

4. The process of social and economic change that began in 18th century England and

resulted in a huge increase in output per worker is called the ___________________.

5. The theory that under-development in developing countries is caused by unequal trade

relations between developing and developed countries is called ____________________.

6. Self-reinforcing patterns of high savings, investment, productivity growth, and

economic expansion, such as experienced by Japan and other “Asian tigers,” are called

_______________________.

7. The idea that poor countries are on a path to “catch up” with the rich countries due to

underlying economic forces, is called ______________________.

8. Aid or loans given by the government of a rich country like the U.S. to a poor country

like Ethiopia is called _________________development assistance.

9. Aid or loans given by international institutions such as the World Bank, IMF, or

United Nations Development Program (UNDP) is called ______________ development

assistance.


10. Suppose a U.S. company builds a factory in China to produce electronic goods.

When such a private company acquires or creates assets for their own business operations

in a foreign country, it is engaging in __________________ investment.

True or False

11. Economic growth will always lead to inflation.

12. The income threshold below which members of a population are classified as poor is

called poverty line.

13. Additions to a nation’s capital stock will automatically lead to economic growth.

14. History shows that having plentiful resources of arable land, energy, and/or minerals

is a requirement for a country to have strong economic growth and development.

15. A system of private property rights is essential for economic growth.

16. Economic growth is a necessary condition for human development.

17. The system of administrative capitalism is characterized by private corporate

ownership and a substantial reliance on public administration as a mode of coordination.


Short Answer

18. Explain the difference between economic growth and economic development.

19. Given data on growth of real GDP and the growth of population, how can growth in

real GDP per capita be calculated?

20. List seven factors that can promote economic growth and development. Are these

factors requirements for achieving economic growth?

21. Explain the idea of convergence.

22. Explain how inflow of remittances has affected development prospects for migrant-

sending countries.

23. What kinds of institutions are beneficial for promoting economic growth and

development?

24. Why have the net official flows from multilateral agencies turned negative in recent

years?

25. Is China more “developed” than India? Explain.


Problems

1. Suppose the following data for the fictitious country Growland:

2016 2017

Real GDP (in 2009 U.S. dollars) 286.9 billion 301.3 billion

Population 220.5 million 223.0 million

a. Calculate the growth in real GDP between 2016 and 2017.

b. Calculate the GDP per capita for 2016 and 2017. (Note that GDP is measured in

billions, while population is measured in millions.

c. Calculate the population growth rate between 2016 and 2017.

d. Calculate the growth rate of GDP per capita.

2. Draw a graph with shifts in the AD/AS curves to illustrate each of the following:

a. Economic growth with inflation rising.

b. Economic growth with inflation falling.


3. Whether worldwide inequality is increasing or decreasing much debated in the press

and popular writings. Some commentators claim that the world is getting much more

equal—“just look at the progress of India and China!” Others claim that the world is

getting much more unequal—“just look at the problems in Sub-Saharan Africa!” This

exercise has you explore data regarding such claims.

a. Using the data in the following table, create a graph showing real GDP per capita on

the horizontal axis and the rate of real GDP per capita growth for 1980-2011 on the

vertical axis. Plot the data for each country.

Country

GDP per Capita, 2016

(PPP, 2011 US $)

Percent Growth in GDP Per

Capita (PPP, Annual Average,

1990-2016)

United States 53,342 1.4

Hong Kong 54,279 2.8

Japan 38,252 1.1

France 38,059 1.0

China 14,399 8.8

India 6,093 4.9

Bangladesh 3,319 3.7

Source: World Bank, World Development Indicators Database, 2017

b. Examining just these selected countries, is there evidence that convergence is

occurring?


c. Now re-do your diagram for the following countries:

Country

GDP per Capita, 2016

(PPP, 201 US $)

Percent Growth in GDP Per

Capita (PPP, Annual Average,

1990-2016)

United States 53,279 2.8

Japan 38,252 1.1

France 38,059 1.0

Turkey 23,756 3.1

Brazil 14,024 1.0

Haiti 1,654 -0.2

Ethiopia 1,608 3.6

Congo, Dem. Rep. 744 -2.2

Source: World Bank, World Development Indicators Database, 2017

d. Now is there evidence that convergence is occurring?

e. What criticism can you make about basing generalizations about world inequality on

studies such as these?


Self Test

1. Suppose in a given year, a country’s real GDP growth rate was 5 percent and its

population grew at 2 percent. Then its per capita real GDP growth rate was:

a. 7%

b. 5%

c. 3%

d. 2%

e. 2.5%

2. If an economy is experiencing economic growth, this is usually shown in the AD/AS

model with

a. a shift to the left of the AS and maximum capacity

b. a shift to the left of the AD curve.

c. a shift to the right of the AD curve.

d. a shift to the right of the AS and maximum capacity

e. a shift to the right of the AS and maximum capacity, together with a shift to the

right of the AD curve.

3. Which of the following is not one of the stages of development in Rostow’s thesis on

how countries progress from “underdevelopment” to “development”?

a. take-off into self-sustaining growth

b. age of high mass consumption

c. drive to maturity

d. unbalanced terms of trade

e. traditional agrarian society

4. The process of social and economic change that began in 18th century England and led

to huge increases in output per worker is called

a. the Democratic Revolution

b. the Communist Revolution

c. the Industrial Revolution

d. the Gender Revolution

e. the Environmental Revolution


5. Which of the following was not one of the factors that contributed to the Industrial

Revolution?

a. New agricultural techniques, new tools and machines that boosted agricultural

productivity.

b. New technologies adopted in factory production that boosted output in

manufacturing.

c. New communication technologies that boosted output in the service sector.

d. Supplies of cheap raw materials from other countries.

e. Access to markets in other countries in which to sell finished products.

6. Which of the following was not one of the main policies promoted in the “Washington

Consensus”?

a. Fiscal discipline

b. Development of infrastructure, health, and education

c. Market liberalization

d. Privatization

e. Trade liberalization

7. Which of the following best characterizes the record of the policies of the

“Washington Consensus”?

a. The countries that most strictly followed the World Bank’s market-oriented

development path suffered the most severe crises.

b. Some countries in Africa were forced to make cutbacks in desperately needed

health and education.

c. Countries were barred from using fiscal policy for macroeconomic stabilization.

d. Some countries that did not follow the Washington Consensus experienced

notable success.


8. Which of the following is one of the trends of global economic growth in the 20th

century?

a. World per capita economic output grew about fivefold.

b. The use of energy more than tripled.

c. Per capita incomes steadily increased.

d. Most of the growth came in the second half of the 20th century.



9. Which of the following factors were key to Japan’s rapid economic growth in the

1950-1980 period?

a. High savings rates.

b. The investment of savings in machines and equipment to boost productivity rates.

c. Investment in human capital.

d. Promotion of exports.


10. Which of the following is a middle-income country?

a. The Congo

b. France

c. Japan

d. Russia

e. Haiti

11. Which of the following characterizes the global distribution of per capita GDP across

countries?

a. Income per person is highest in the industrialized countries.

b. Income per person is lowest in many African and Asian countries.

c. The income per person in many industrialized countries such as U.S., Canada,

Europe, and Japan is more than $25,000.

d. Many of the low-income countries in sub-Sahara have income per capita lower

than $2,500.


12. Which of the following has clearly NOT been converging to rich country income

levels since 1990?

a. Democratic Republic of Congo

b. South Korea

c. Ethiopia

d. China

e. India


13. Which of the following is NOT considered by economists to be a source of economic

growth?

a. Natural resources

b. Consumption

c. Savings and investment

d. Foreign sources of capital

e. Financial, legal, and regulatory institutions

14. A national system combining private ownership of capital with substantial reliance on

government as a mode of coordination is known as

a. market socialism

b. administrative capitalism

c. impure communism

d. fascism

e. welfarism

15. Among variables NOT considered in the multidimensional poverty index are

a. income inequality

b. child mortality

c. school attendance

d. cooking fuel

e. drinking water

16. The Sustainable Development Goals

a. have already largely been achieved

b. were introduced to the public by the World Bank

c. place greatest emphasis on reversing climate change

d. can be achieved indirectly with global GDP growth



17. The Kuznets curve hypothesis states that

a. inequality will intensify in a country as it grows richer, but beyond a certain point

it will diminish.

b. inequality will steadily decrease as a county grows richer

c. inequality will increase as a country grows richer

d. a country’s income level mattered more to inequality in the era of colonies

e. The hypothesis does not say anything about inequality.

18. Which of the following is not one of the ingredients that can stimulate economic growth?

a. Savings and investment.

b. Technological innovation and entrepreneurship.

c. Access to domestic and international markets.

d. Contractionary macroeconomic policies to slow down aggregate demand.

e. Access to foreign capital.

19. From what sources can a developing country acquire funds to finance investments?

a. From domestic savings.

b. From bilateral assistance.

c. From multilateral assistance.

d. From private foreign banks.


20. Approximately how much in development assistance (as a % of GDP) do the rich

countries give to poor developing countries?

a. Less than 1%

b. About 1%

c. About 3%

d. About 5%

e. About 10%



1. growth

2. development

3. capabilities

4. Industrial Revolution

5. dependency theory

6. virtuous cycles (in development)

7. convergence

8. bilateral

9. multilateral

10. foreign direct (investment)

11. False. The effect of economic growth on inflation is ambiguous. If the AS curve shifts

further to the right than the AD curve, the inflation rate may decline. If the AD curve

shifts further to the right than the AS curve, the inflation rate may rise.

12. True.

13. False. Poorly planned or misguided development projects may lead to waste or even

harm.

14. False. While natural resources are generally very important, there are some

economies with few natural resources that have done very well (e.g. Hong Kong and

Singapore, which are natural ports but have little energy or mineral resources or

arable land).

15. False. Some countries, like China and Vietnam, have been successful in achieving

economic growth without a system of private property rights.

16. False. Economic growth often helps, but it is not required. Human development has

many dimensions, and it could be achieved through progress in many different areas

unrelated to income.

17. True.

18. Economic growth is the growth in production of output (or income), and can be

measured as the percent change in real GDP. Economic development is the

movement of the population from poverty into a situation of material plenty or well-

being. Development is a much broader concept than growth, as it includes

improvement in the quality of living through changes in non-income aspects such as

access to better nutrition and housing, progress in quality of education and healthcare,

decline in crime rates, and improvement in environmental quality.

19. Growth in real GDP per capita = growth in real GDP – growth in population.

20. The factors that can promote economic growth include: savings and investment,

technological innovation and entrepreneurship, good macroeconomic policies that

stabilize aggregate demand, access to international markets, availability of natural

resources, access to foreign capital, and good institutions. These factors are not

requirements for economic growth, however, as there are many examples of countries

that have achieved growth without one or more of these factors.

21. The idea of convergence is that the poor countries are on a path to “catch up” with the

rich countries, because they are starting off with little capital. So as they experience

increases in their manufactured capital stock, their output will grow at a faster rate

than that of rich countries that are already rich in manufactured capital.


22. Remittances are a significant source of financial capital (much greater than aid) for

many of the poor migrant-sending countries. Research on the impacts of remittances

show gains in income and improvement in other aspects of well-being such as access

to healthcare and education.

23. The beneficial institutions include: a good banking system; a good legal system with

private property rights and contact enforcement; and the absence of corruption,

internal conflict, and political instability.

24. Because developing countries are currently paying back more due to their heavy debt

burdens, than what they receive in new loans.

25. Despite rapid economic growth in both countries in recent decades, China has made

significantly more progress in improving the capabilities of its people. It has placed a

greater priority in eliminating hunger, illiteracy, and medical neglect, and developing

the economic potential of its population. However, India is ahead of China in terms of

human freedom as it is a democracy, while China’s government is authoritarian. Most

of the development efforts in China has come from its leaders without much pressure

from the public. In India, on the other hand, public protests and court decisions play a

central role in influencing the process of development.

Answers to Problems

1.

a. [(301.3 286.9) / 286.9] × 100 = 5.0%

b. Real GDP per capita for 2016 = $286,900,000,000 / 220,500,000 = $1,301

Real GDP per capita for 2017 = $301,300,000,000 / 223,000,000 = $1,351

c. [(223.0 220.5)/220.5] × 100 = 1.1%

d. 5.0% 1.1% = 3.9%

Calculating the percentage change in real GDP per capita from part b, as (1351-

1301)/1301 × 100, gives a rate of 3.8%. This is also an acceptable answer.

Technical Note: The simple formula given for figuring percentage changes is to blame

for the discrepancy between the two answers. In practice, economists often use a different

formula--the “log-difference formula”--to calculate percentage changes. Using the “ln”

(natural log) function on a calculator or spreadsheet, the equation [ln(GDP2017) -

ln(GDP2016)] × 100 gives a measure of percentage change. Using this method of

calculating percentage changes, there would be no discrepancies (except due to

rounding.)

2.

a. Economic growth with inflation rising.


b. Economic growth with inflation falling.

3.

a.


b. Yes, looking only at this evidence, it would appear that convergence may be occurring.

The poorer countries tend, on balance, to have faster growth rates than the richer

countries, and are on the path to “catch up” to them.

0

1

2

3

4

5

6

7

8

9

0 10,000 20,000 30,000 40,000 50,000 60,000

GDP per capita, 2016 (PPP, 2011 US$)

Pe

rce

nt

Gro

wth

in G

DP

pe

r C

apit

a (P

PP,

an

nu

al a

vera

ge, 1

99

0 –

20

16

)


c.

d. Now it does not appear that convergence is occurring, because the poor countries are

growing at rates generally less than those of the developed countries.

e. Neither “study” looks at the whole picture.


1. C

2. E

3. D

4. C

5. C

6. B

7. E

8. E

9. E

10. D

11. E

12. A

13. B

14. B

15. A

16. E

17. A

18. D

19. E

20. A

0

0.5

1

1.5

2

2.5

3

3.5

4

0 10,000 20,000 30,000 40,000 50,000 60,000

GDP per capita, 2016 (PPP, 2011 US$)

Pe

rce

nt

Gro

wth

in G

DP

pe

r C

apit

a (P

PP,

an

nu

al a

vera

ge, 1

99

0 –

20

16

)

Chapter 18 – Growth And Sustainability in the 21st Century 1

Chapter 18

GROWTH AND SUSTAINABILITY IN THE TWENTY-FIRST CENTURY Macroeconomics in Context (Goodwin et al.)

Chapter Overview

This chapter examines ecological challenges and their implications for macroeconomic

growth. It considers the problems of population, resource depletion, climate change, and

possible limits to economic growth, putting earlier analysis of aggregate demand and

economic growth into a new framework emphasizing sustainability. The chapter

discusses theories of the relationship between economic growth and the environment,

such as the Environmental Kuznets Curve (EKC). It looks at possible alternatives to

indefinite economic growth, including theories of the steady-state economy. Analyses of

resource limits and environmental impacts raise serious challenges to the belief that

economic growth and markets, on their own, will solve the social and environmental

problems of the coming century. The chapter concludes with a discussion of institutions

and policies to promote sustainable development.

Chapter Objectives


1. Recognize ecological sustainability as a major economic issue for the 21st century.

2. Identify major environmental challenges.

3. Understand the relationship of climate change to economic growth.

4. Be familiar with the Environmental Kuznets Curve and its limitations.

5. Understand the concepts of limits to growth and a steady-state economy

6. Describe several policies directed towards sustainable development.

Key Terms

weak sustainability

strong sustainability

ecological footprint

nonrenewable resources

social cost of carbon

social discount rate

environmental Kuznets curve (EKC)

hypothesis

steady-state economy

throughput


Active Review

Fill in the Blank

1. The ________________ approach measures the human impacts on the environment in

terms of the land area required to supply a society’s resources and assimilate its wastes

and pollution.

2. Major environmental issues for the twenty-first century include ________________,

____________________, and ______________________.

3. Resources that do not regenerate through natural processes, at least on a human time

scale, such as oil, coal, and mineral ores are called ________________.

4. Emissions of __________________________lead to global warming and climate

change.

5. The ___________________________ agreement allowed each country set their own

emissions targets on a voluntary basis and enact national policies to meet these targets.

6. The two most prominent market-based policies for addressing climate change are

________________ and ________________.

7. The __________________ curve posits an inverted U-shaped relationship between

economic development and environmental damages, suggesting that as nations develop

their damage to the environment decreases.

8. Taxes that are used as a means to internalize the negative externalities from pollution

are called ________________________.

9. A discount rate that reflects social rather than market valuation of future costs and

benefits, and is usually lower than the market discount rate, is called a

_____________________.

10. An economy with no increase in population, or in the rate of use of raw-materials and

energy is termed ________________.

True or False

11. The world population exceeded 7.5 billion in 2018, and the United Nations medium

range projections show global population of 10 billion people in 2050.

12. As of 2016, the OECD nations comprise the majority of global emissions of carbon

dioxide.


13. According to leading scientists, global emissions of greenhouse gases will eventually

need to be reduced significantly—up to 50 percent lower than current levels by 2050—if

we are to avoid the most dangerous effects of climate change.

14. Environmental damage per capita tends to decline with increasing income for all

major pollutants.

15. One of the limitations of green taxes is that they are regressive, likely falling

disproportionately on lower-income households.

16. Tradable permit systems allow overall pollution to increase since businesses can

purchase permits to pollute.

Short Answer

17. Distinguish between the “weak” and “strong” perspectives on sustainability. What are

some of the indicators that can be used to measure each of these?

18. Identify three environmental issues that are closely related to economic growth.

19. What kinds of environmental problems are associated with the increasing global

human population?

20. What are some of the problems predicted to occur with rising levels of greenhouse

gas emissions?

21. What is the Environmental Kuznets Curve (EKC) hypothesis? And what is the

evidence for this hypothesis?

22. Identify at least three policies for sustainable development.


Self Test

1. Which of the following statements describes the “strong” version of

sustainability?

a. Two trees are planted to replace each tree cut in the production of timber.

b. Trees are cut for the production of timber, and the value of timber produced is

estimated to be higher than the value of tree lost.

c. Trees are cut for producing timber, and the value of timber produced is

estimated to be lower than the value of tree lost.

d. Both (a) and (b)


2. According to United Nations median projections published in 2017, global

population is expected to:

a. Increase to 8 billion by 2050

b. Decrease to 6 billion by 2050

c. Remain approximately constant

d. Increase to nearly 10 billion by 2050

e. Increase to 11 billion by 2050

3. Which of the following resources are currently being depleted or at risk of depletion?

a. Fisheries

b. Forests

c. Clean water for drinking and agriculture

d. Minerals and fossil fuels


4. Which of the following statements about the level of air pollution is FALSE?

a. Air pollution has mostly increased in both developing countries and developed

countries in recent years.

b. Air pollution in most major cities in developing countries exceed the World

Health Organization’s recommended levels.

c. The most common air pollutants in the U.S. have declined by 73% since the

1970s.

d. Efforts to reduce pollution levels have generally been found to be cost-effective.



5. Which of the following are not among the adverse effects of greenhouse gas

emissions?

a. Rising temperatures.

b. Rising sea-levels.

c. Ecological disruptions such as species extinction.

d. Increased frequency of severe weather events such as hurricanes, floods, and

droughts.

e. Depletion of mineral resources.

6. Which of the following countries is the world’s top emitter of carbon dioxide?

a. India

b. United States

c. Russia

d. Saudi Arabia

e. China

7. Which of the following was the conclusion of the 2006 British government report

written by former World Bank chief economist Nicholas Stern?

a. The costs of climate change in the twenty-first century are estimated as equivalent

to 5–20 percent of global GDP, while the most severe effects of climate change

could be avoided at a cost of around only 1 percent of global GDP.

b. The costs of climate change in the twenty-first century are estimated as equivalent

to 1 percent of global GDP, while the most severe effects of climate change could

only be avoided at a cost of around 5 - 20 percent of global GDP.

c. It now appears that the benefits of current actions to minimize climate change

significantly exceed the costs.

d. (a) and (c)


8. If nothing is done now to stem the effects of climate change, what group will face the

most dangerous impacts from climate change?

a. Current generations

b. Future generations living several decades from now or later

c. Developed countries

d. Developing countries

e. (b) and (d)


9. Why do some researchers suggest that when economic development increases,

environmental damage (per capita) will decrease?

a. Because the greater availability of wealth and technology allows nations to adopt

cleaner production methods.

b. Because as countries develop, they move to a service-based economy which does

less harm to the environment.

c. Because as people become wealthier, they demand higher environmental quality

standards.

d. All of the above.


10. The Environmental Kuznets Curve (EKC) hypothesis posits that:

a. Environmental damage per capita increases in the early stages of economic

development, reaches a maximum, and then diminishes as a nation attains higher

levels of income.

b. Environmental damage per capita falls in the early stages of economic

development, reaches a minimum, and then rises as a nation attains higher levels

of income.

c. Environmental damage per capita steadily rises during all stages of economic

development.

d. Environmental damage per capita steadily falls during all stages of economic

development.

e. There is no clear relationship between environmental damage per capita and

economic development, as it depends on the country, the pollutant, and other

contingencies.

11. The evidence for the Environmental Kuznets Curve (EKC) suggests that:

a. The EKC relationship does seem to hold for all pollutants.

b. The EKC relationship does not seem to hold for any pollutants.

c. The EKC relationship does seem to hold for some pollutants, such as per capita

sulfur dioxide emissions and other air pollutants, but not for CO2 emissions.

d. The EKC relationship does seem to hold for the environmental impacts of CO2

emissions, but not for per capita sulfur dioxide emissions and other air pollutants.

e. The EKC relationship does seem to hold for some countries, but not others.


For the following question, refer to the figure below.

12. The figure above, showing the relationship between GDP per capita and CO2

emissions:

a. Indicates that developing countries typically have high per capita CO2 emissions.

b. Show that there is no relationship between GDP and CO2 emissions.

c. Provides evidence that confirms the Environmental Kuznets Curve hypothesis.

d. Provides evidence that does not support the Environmental Kuznets Curve

hypothesis.


13. Which of the following is not a consequence of instituting carbon taxes on large

emitters of CO2?

a. reduction in overall levels of CO2 emission

b. effective control on the overall level of emissions by the government

c. increase in tax revenue for the government

d. increased investment in renewable technology

e. higher utility bills for consumers

14. Which of the following statements about the 2015 Paris Climate Agreement is

FALSE?

a. Each country is allowed set their own targets and participation is voluntary.

b. There are no enforceable penalties for failing to meet targets.

c. Most countries are on track to achieve the treaty’s objective of limiting global

warming to no more than 2◦C above preindustrial levels.

d. An overall evaluation of the treaty shows that it has resulted in a reduction in the

expected increase in temperature levels.



15. Which of the following is not a policy to promote environmental sustainability?

a. Green taxes.

b. Grants, subsidies and tax breaks to support recycling, renewable energy, and

efficient transportation systems.

c. Tax cuts to stimulate consumption spending.

d. Elimination of subsidies for environmental degrading activities.

e. Tradable pollution permits.

16. According to the macroeconomic model developed by the United Nations, an annual

investment of 2% of the global GDP over 2010-2050 to fund sustainable technologies

relative to the business-as-usual (BAU) scenario will:

a. initially reduce the global GDP per capita by about 1 percent.

b. increase the global GDP per capita by 2% by 2030.

c. increase the global GDP per capita by 14% by 2050.

d. Reduce global energy demand by 40%.

e. All of the above

17. Which of the following is not among the recommendations proposed by Tim Jackson

in transitioning to a sustainable economy?

a. structural transition towards service-based activities

b. investment in infrastructure development

c. investment in ecological assets

d. a decline in working hours per week

e. Both (b) and (d)


a. Green taxes discourage energy-intensive economic activities.

b. Environmental taxes in industrial countries range from less than 3% to around

10%.

c. Green taxes are strongly supported by economic theory as a means of

internalizing negative externalities.

d. Environmental taxes as a percentage of overall taxes is higher in United States

than it is in Spain, Germany, Sweden or United Kingdom.



19. Which of the following policies is not favorable for transitioning to a more

sustainable economy?

a. Increase subsidies to the fossil fuel industry.

b. Increase investment in agriculture systems to encourage crop diversification.

c. Impose taxes on large emitters of CO2.

d. Invest in renewable energy.

e. Institute a system of tradable permits.

20. How can macroeconomic policy deal with environmental considerations?

a. Seek to modify both the level and composition of consumption spending.

b. Promote forms of investment that do not increase the “throughput” of natural

resources and the creation of wastes.

c. Direct government spending towards promoting environmental sustainability.

d. Promote investments that are more future-oriented than those concerned with

short-term considerations.




1. ecological footprint

2. population, resource depletion, and pollution and wastes

3. nonrenewable resources

4. greenhouse gases including CO2

5. 2015 Paris Climate (Agreement)

6. carbon taxes; a system of tradable permits

7. Environmental Kuznets (Curve)

8. green taxes

9. social discount rate

10. steady-state economy

11. True.

12. False – OECD nations comprised the majority of global emissions of CO2 until 2003,

but by 2016 over 60% of the world’s CO2 was emitted by non-OECD nations.

13. False – scientific research indicates that the reduction in greenhouse gases needs to be

70 percent or more by 2050 to avoid major destructive impacts.

14. False – a declining trend is noted for some pollutants above about $5,000 in per capita

income, but other pollutants continue to increase as incomes rise.

15. True.

16. False. Tradable permit systems allow individual business to purchase permits for

pollution, but set an overall limit on the total amount of pollution emitted.

17. The “weak sustainability” perspective asserts that the depreciation of natural capital is

justified as long as there is an adequate increase in any other types of capital, while

the “strong sustainability” perspective argues that the depreciation of natural capital is

only justified if there is an adequate increase in some form of natural capital.

Indicators such as GPI and Green GDP can be used for “weak sustainability” and

satellite accounts such as forested area, waste generation, and greenhouse gas

emissions can be used for “strong sustainability”.

18. Global population, depletion of renewable and non-renewable resources, and

pollution and wastes.

19. The increasing global human population necessitates increasing food supplies, which

has led to environmental problems such as: land degradation, pollution from

fertilizers and pesticides, and overdraft of water supplies.

20. The problems include: Rising temperatures, rising sea-levels and coastal flooding,

decrease in water supplies, declines in crop yields, increase in food insecurity,

ecological disruptions such as species extinction, spread of malaria and other tropical

diseases, and increased frequency of severe weather events such as hurricanes, floods,

and droughts.

21. The Environmental Kuznets Curve (EKC) hypothesis says that environmental

damage per capita increases in the early stages of economic development, reaches a

maximum, and then diminishes as a nation attains higher levels of income. The EKC

relationship does seem to hold for some pollutants, such as per capita sulfur dioxide

emissions and other air pollutants, but not for the environmental impacts of municipal

waste, energy use, and CO2 emissions.


22. Green taxes and tradable pollution permits; Grants, subsidies and tax breaks to

support recycling, renewable energy, and efficient transportation systems;

Elimination of subsidies for environmental degrading activities.


1. A

2. D

3. E

4. A

5. E

6. E

7. D

8. E

9. D

10. A

11. C

12. D

13. B

14. C

15. C

16. E

17. B

18. D

19. A

20. E

student study guide · 2019. 6. 11. · student study guide macroeconomics in context third edition...

Documents